Working Paper: NBER ID: w9275
Authors: Jonathan B. Berk; Richard C. Green
Abstract: We develop a simple rational model of active portfolio management that provides a natural benchmark against which to evaluate observed relationship between returns and fund flows. We show that many effects widely regarded as anomalous are consistent with this simple explanation. In the model, investments with active managers do not outperform passive benchmarks because of the competitive market for capital provision, combined with decreasing returns to scale in active portfolio management. Consequently, past performance cannot be used to predict future returns, or to infer the average skill level of active managers. The lack of persistence in active manager returns does not imply that differential ability across managers is nonexistent or unrewarded, that gathering information about performance is socially wasteful, or that chasing performance is pointless. A strong relationship between past performance and the ow of funds exists in our model, indeed this is the market mechanism that ensures that no predictability in performance exists. Calibrating the model to the fund flows and survivorship rates, we find these features of the data are consistent with the vast majority (80%) of active managers having at least enough skill to make back their fees.
Keywords: Mutual Funds; Performance; Portfolio Management; Capital Markets
JEL Codes: G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| active managers' investments do not outperform passive benchmarks (G11) | competitive market dynamics (D43) |
| past performance cannot predict future returns (G17) | competitive market dynamics (D43) |
| strong relationship between past performance and fund flows (G41) | lack of predictability in future performance (D80) |
| investors interpret high past performance as evidence of managerial skill (G14) | increased fund flows (G23) |
| increased fund flows (G23) | expected excess returns are competitive (G12) |
| observed behaviors of mutual fund flows and performance (G41) | presence of skilled managers who can generate excess returns (D29) |