Mutual Fund's R2 as Predictor of Performance

We propose that fund performance can be predicted by its R2, obtained from a regression of its returns on a multi-factor benchmark model. Lower R2 indicates greater selectivity and it significantly predicts better performance. Stock funds sorted into lowest-quintile lagged R2 and highest-quintile lagged alpha produce significant annual alpha of 3.8%. Across funds, R2 is positively associated with fund size and negatively associated with its expenses and manager's tenure.