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Mutual Fund Flows and Performance in Rational Markets

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  • 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 nd 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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9275.

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Date of creation: Oct 2002
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Publication status: published as Berk, Jonathan B. and Richard C. Green. "Mutual Fund Flows and Performance in Rational Markets." Journal of Political Economy 112 (2004), 1269-1295.
Handle: RePEc:nbr:nberwo:9275

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  1. Dan Bernhardt & Ryan Davies & Harvey Westbrook Jr., 2002. "Smart Fund Managers? Stupid Money?," ICMA Centre Discussion Papers in Finance, Henley Business School, Reading University icma-dp2002-19, Henley Business School, Reading University, revised Jul 2003.
  2. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, American Finance Association, vol. 52(1), pages 57-82, March.
  3. Erik R. Sirri & Peter Tufano, 1998. "Costly Search and Mutual Fund Flows," Journal of Finance, American Finance Association, American Finance Association, vol. 53(5), pages 1589-1622, October.
  4. 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, University of Chicago Press, vol. 35(1), pages 45-70, April.
  5. Holmstrom, Bengt, 1999. "Managerial Incentive Problems: A Dynamic Perspective," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 66(1), pages 169-82, January.
  6. Chevalier, J. & Ellison, G., 1996. "Risk Taking by Mutual Funds as a Response to Incentives," Working papers, Massachusetts Institute of Technology (MIT), Department of Economics 96-3, Massachusetts Institute of Technology (MIT), Department of Economics.
  7. 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, American Finance Association, vol. 51(1), pages 85-110, March.
  8. Ippolito, Richard A, 1989. "Efficiency with Costly Information: A Study of Mutual Fund Performance, 1965-1984," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 104(1), pages 1-23, February.
  9. William N. Goetzmann & Stephen J. Brown, 2005. "Performance Persistence," Yale School of Management Working Papers, Yale School of Management ysm451, Yale School of Management.
  10. Lu Zheng, 1999. "Is Money Smart? A Study of Mutual Fund Investors' Fund Selection Ability," Journal of Finance, American Finance Association, American Finance Association, vol. 54(3), pages 901-933, 06.
  11. Chordia, Tarun, 1996. "The structure of mutual fund charges," Journal of Financial Economics, Elsevier, Elsevier, vol. 41(1), pages 3-39, May.
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