Unencumbered by Style : Why do Funds Change Factor Loadings and Does it Help?

This paper shows that mutual funds tend to substantially alter their factor loadings following quarters in which they either under- or out-perform other funds based on returns or fund flows. These loadings changes are not mechanical but rather a result of deliberate trading decisions. We propose a new measure of manager skill, ``flexible-style investing skill,'' that is based on a manager’s ex-ante observable skill to use loadings changes to increase future returns. We show that more skilled managers earn significantly higher raw and risk-adjusted returns than the less skilled managers in the following quarter. This outperformance is more pronounced following quarters with large loadings changes