Working Paper: NBER ID: w17491
Authors: Diane Del Guercio; Jonathan Reuter
Abstract: Financial economists have long been puzzled by investor demand for actively managed funds that generate, on average, negative after-fee, risk-adjusted returns. To shed new light on this puzzle, we exploit the fact that funds in different market segments compete for different types of retail investors. Within the segment of funds marketed directly to retail investors, we find that flows chase risk-adjusted returns, and that funds respond by investing more in active management. Importantly, within this direct-sold segment, we find little evidence that actively managed funds underperform index funds. In contrast, within the segment of funds sold through brokers, which we demonstrate face a weaker incentive to generate alpha, we find that actively managed funds significantly underperform index funds. We conclude that the well-known underperformance of the average actively managed fund in the full sample is driven by the large fraction of funds with weak incentives to identify and motivate skilled managers.
Keywords: Mutual Funds; Performance; Alpha; Investor Behavior
JEL Codes: G14; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Funds sold directly to retail investors (G23) | Stronger incentive to generate alpha (G19) |
| Stronger incentive to generate alpha (G19) | Flows into direct-sold funds are more sensitive to risk-adjusted returns (G23) |
| Flows into direct-sold funds are more sensitive to risk-adjusted returns (G23) | More likely to invest in active management (G11) |
| Brokersold funds (G23) | Weaker relationship between flows and performance (D29) |
| Weaker relationship between flows and performance (D29) | Disincentive to generate alpha (G19) |
| Direct-sold funds (G23) | Higher alphas (C69) |
| Direct-sold funds (G23) | Lower betas (C46) |
| Direct-sold funds (G23) | Better performance metrics (C52) |
| Underperformance of actively managed funds (G23) | Driven by large number of brokersold funds (G23) |