So now, let's sort mutual funds by their past R squared.

So how much of the returns are simply explained by common factors, okay?

So here we have five groups here.

The high group, those are mutual funds,

the 20% mutual funds with the highest R squared.

So these are basically your closet index funds,

in that they say they're actively managed.

But basically the market conditions, the size composition, the value composition

of portfolio seem to explain a lot of what's happening with the returns.

So a 100% small cap fund or 100% value fund that are just

following an index of small stocks and value stocks.

They would be in this group five here of having a high R squared.

Group one, the lowest group group,

those are the funds that have the lowest R squared.

So those are the funds where the managers are being more active.

That might be good or bad, but at least they're trading.

They're not kind of following the index fund.

And if you buy an actively managed fund, presumably you want your manager that's

making decisions to try and beat the market.

You just don't want to buy an index fund that's being labeled, actively managed.

Okay, so let's focus on the results here,

where they R squared of the mutual fund, over the past 24 years,

is basically on the high side, groups three, four, and five.

What do you see going forward?

All three of these groups under perform their benchmark by about 1 to

1.5% on an annual basis.

What does that reflect?

Well these groups here that have this high R squared,

particularly groups four and five, they're basically closet index funds.

So we know since they're an index fund their alpha before fees is basically

going to be zero, in the three-factor or four-factor model.

Once you subtract out these high fees, that's charged by the active management

fund manager, you get this negative performance.

So these are the mutual funds to definitely avoid.

You don't want to pay for active management.

If your mutual fund manager is simply sitting back and

investing in an index fund.

Okay, if they're doing index funds,

you want to pay the low fees associated with index funds.

Thus these big negative returns going forward for

funds that have high R squared.

They're closet index funds, charging you too much.

How about when we do a dual sort here, okay?

We're going to look at high R squared, and

high alpha, that's what we want to kind of look at.

Now when we look at just R squared being low,

we see those funds that have a low R squared going forward.

Their return beats its benchmark by 0.6%.

So there is a little evidence that, hey,

those active funds that are more active, maybe they are not doing so bad.

They are beating there benchmark by 0.6 percent.

This standard error though is pretty high.

So this is not a statistically significant result.

The coefficient is positive, positive alpha, but

it's not statistically significant.

But what if we investigate further and

do a breakdown where we look at both past R squared and past alpha.

So for example we look at these mutual funds here

where they all have low R squared.

So they all have a lot of active management, they're

in the bottom 20% when it comes to past 24 months, R squared from the regression.

And then let's further condition on,

we know that the managers doing a lot of trades, isn't a closet indexer,

was their past alpha over the last 24 months low or high?

And when you look at this group,

we actually find, if I hadn't thrown away the divining rod, now would be the point

in time where it's going crazy here if it was set to find good investments.

Because here we see some predictability.

So if you have mutual funds that in the past there was a low R squared from

the regression.

Indicating that the managers, doing some active management,

is trying to trade, is not just following the market.

And over the past two years,

they have this track record of doing well in terms of you know getting a high alpha.

There is some predictability for

the next month of these funds continuing to do well.

On an annual basis, they are outperforming their benchmark

by 1.7 to 3.8% on an annual basis.

So some predictability, look for the mutual funds that have a low R squared,

it means the manager's making active decisions.

Over the past two years they have a track record of beating their benchmark.

That positive alpha seems to continue at least over the next month.