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Mutual Fund Flows and Performance in Rational Markets

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  • Jonathan B. Berk

    ()
    (Haas School of Business, University of California, Berkeley and NBER)

  • Richard C. Green

    ()
    (Graduate School of Industrial Administration, Carnegie Mellon University)

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. 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 actively managed 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 flow of funds exists in our model: indeed, this is the market mechanism that ensures that no predictability in performance exists. Choosing parameters to match the flow-performance relationship 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.

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Bibliographic Info

Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp100.

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Date of creation: Dec 2002
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Handle: RePEc:fam:rpseri:rp100

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  1. Brown, Stephen J & Goetzmann, William N, 1995. " Performance Persistence," Journal of Finance, American Finance Association, vol. 50(2), pages 679-98, June.
  2. Bengt Holmstrom, 1999. "Managerial Incentive Problems: A Dynamic Perspective," NBER Working Papers 6875, National Bureau of Economic Research, Inc.
  3. Judith A. Chevalier & Glenn D. Ellison, 1995. "Risk Taking by Mutual Funds as a Response to Incentives," NBER Working Papers 5234, National Bureau of Economic Research, Inc.
  4. Brown, Keith C & Harlow, W V & Starks, Laura T, 1996. " Of Tournaments and Temptations: An Analysis of Managerial Incentives in the Mutual Fund Industry," Journal of Finance, American Finance Association, vol. 51(1), pages 85-110, March.
  5. Dan Bernhardt & Ryan Davies & Harvey Westbrook Jr., 2002. "Smart Fund Managers? Stupid Money?," ICMA Centre Discussion Papers in Finance icma-dp2002-19, Henley Business School, Reading University, revised Jul 2003.
  6. Chordia, Tarun, 1996. "The structure of mutual fund charges," Journal of Financial Economics, Elsevier, vol. 41(1), pages 3-39, May.
  7. Erik R. Sirri & Peter Tufano, 1998. "Costly Search and Mutual Fund Flows," Journal of Finance, American Finance Association, vol. 53(5), pages 1589-1622, October.
  8. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
  9. Lu Zheng, 1999. "Is Money Smart? A Study of Mutual Fund Investors' Fund Selection Ability," Journal of Finance, American Finance Association, vol. 54(3), pages 901-933, 06.
  10. Ippolito, Richard A, 1992. "Consumer Reaction to Measures of Poor Quality: Evidence from the Mutual Fund Industry," Journal of Law and Economics, University of Chicago Press, vol. 35(1), pages 45-70, April.
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