This paper is based on the premise that knowledge about the alphas of one set of funds will influence an investor's beliefs about other funds. This will be true insofar as an investor's expectation about the performance of a fund is partly a belief about the abilities of mutual fund managers as a group and, more generally, a belief about the degree to which financial markets are efficient. We develop a simple framework for incorporating this prior dependence' and find that it can have a substantial impact on the cross-section of posterior beliefs about fund performance as well as asset allocation. Under independence, the maximum posterior mean alpha increases without bound as the number of funds increases and 'extremely large' estimates are randomly observed. This is true even when fund managers have no skill. In contrast, with prior dependence, investors aggregate information across funds to form a general belief about the potential for abnormal performance. Each fund's alpha estimate is shrunk toward the aggregate estimate, mitigating extreme views. An additional implication is that restricting the estimation to surviving funds, a common practice in this literature, imparts an upward bias to the average fund alpha.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
9392.
Length: Date of creation: Dec 2002 Date of revision: Handle: RePEc:nbr:nberwo:9392
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References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Luboš Pástor & Robert F. Stambaugh, .
"Investing in Equity Mutual Funds,"
CRSP working papers
532, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
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