Working Paper: CEPR ID: DP15548
Authors: Magnus Dahlquist; Markus Ibert; Felix Wilke
Abstract: We recover a forward-looking distribution of expected abnormal returns (alphas) for active equity mutual funds from analyst ratings. Professional analysts believe that alphas are dispersed, that the average fund will underperform, and that the largest funds will outperform. We estimate a rational expectations learning model of fund performance and confront the model-implied expectations based on fund size, perceived skill, and fees with analysts' expectations. Analysts and the rational learner respond similarly to changes in perceived skill and fees, but in contrast to the rational learner, analysts do not believe in a negative impact of fund size on fund returns. The absence of such decreasing returns to scale in analysts' expectations and the presence thereof in actual fund returns make it difficult to reconcile analysts' expectations with rational expectations, but can help explain the size of the industry together with its poor performance.
Keywords: alpha; expectation formation; mutual funds
JEL Codes: G11; G12; G14; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Analysts do not form their expectations according to the rational expectations model (D84) | Analysts expect returns to increase with fund size (G23) |
| Analysts expect returns to increase with fund size (G23) | Actual fund returns decrease with size (L25) |
| Absence of decreasing returns to scale in analysts' expectations (D24) | Presence of decreasing returns to scale in actual fund performance (D24) |
| Analysts overreact to past performance (G41) | Analysts' beliefs about fund performance are not aligned with actual fund performance dynamics (G41) |
| One-unit increase in log size (C29) | 0.008 percentage point larger alpha (C29) |
| One-unit increase in log size (C29) | 0.019 percentage point smaller alpha (predicted by rational expectations model) (E17) |