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Evaluating and Investing in Equity Mutual Funds

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  • LUBOS PASTOR
  • ROBERT F. STAMBAUGH

Abstract

Our framework for evaluating and investing in mutual funds combines observed returns on funds and passive assets with prior beliefs that distinguish pricing-model inaccuracy from managerial skill. A fund's alpha' is defined using passive benchmarks. We show that returns on non-benchmark passive assets help estimate that alpha more precisely for most funds. The resulting estimates generally vary less than standard estimates across alternative benchmark specifications. Optimal portfolios constructed from a large universe of equity funds can include actively managed funds even when managerial skill is precluded. The fund universe offers no close substitutes for the Fama-French and momentum benchmarks.

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Paper provided by Center for Research in Security Prices, Graduate School of Business, University of Chicago in its series CRSP working papers with number 516.

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Handle: RePEc:wop:chispw:516

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  1. Robert F. Stambaugh, 1997. "Analyzing Investments Whose Histories Differ in Length," NBER Working Papers 5918, National Bureau of Economic Research, Inc.
  2. Lubos Pástor & Robert F. Stambaugh, . "Costs of Equity Capital and Model Mispricing," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 04-98, Wharton School Rodney L. White Center for Financial Research.
  3. Chen, Zhiwu & Knez, Peter J, 1996. "Portfolio Performance Measurement: Theory and Applications," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 9(2), pages 511-55.
  4. Lubos Pástor, 2000. "Portfolio Selection and Asset Pricing Models," Journal of Finance, American Finance Association, American Finance Association, vol. 55(1), pages 179-223, 02.
  5. Daniel, Kent, et al, 1997. " Measuring Mutual Fund Performance with Characteristic-Based Benchmarks," Journal of Finance, American Finance Association, American Finance Association, vol. 52(3), pages 1035-58, July.
  6. Lubos Pastor & Robert F. Stambaugh, 1999. "Comparing Asset Pricing Models: An Investment Perspective," NBER Working Papers 7284, National Bureau of Economic Research, Inc.
  7. Kent Daniel & Sheridan Titman, 1996. "Evidence on the Characteristics of Cross Sectional Variation in Stock Returns," NBER Working Papers 5604, National Bureau of Economic Research, Inc.
  8. Tobias J. Moskowitz & Mark Grinblatt, . "Do Industries Explain Momentum?," CRSP working papers, Center for Research in Security Prices, Graduate School of Business, University of Chicago 480, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  9. Mark Grinblatt & Sheridan Titman, . "Portfolio Performance Evaluation: Old Issues and New Insights," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 22-88, Wharton School Rodney L. White Center for Financial Research.
  10. Kandel, Shmuel & Stambaugh, Robert F., 1987. "On correlations and inferences about mean-variance efficiency," Journal of Financial Economics, Elsevier, Elsevier, vol. 18(1), pages 61-90, March.
  11. Brown, Stephen J & Goetzmann, William N, 1995. " Performance Persistence," Journal of Finance, American Finance Association, American Finance Association, vol. 50(2), pages 679-98, June.
  12. 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.
  13. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, Econometric Society, vol. 50(4), pages 1029-54, July.
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  17. Klein, Roger W. & Bawa, Vijay S., 1976. "The effect of estimation risk on optimal portfolio choice," Journal of Financial Economics, Elsevier, Elsevier, vol. 3(3), pages 215-231, June.
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  19. repec:fth:pennfi:72 is not listed on IDEAS
  20. Fama, Eugene F & French, Kenneth R, 1996. " Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, American Finance Association, vol. 51(1), pages 55-84, March.
  21. Klaas Baks & Andrew Metrick & Jessica Wachter, 1999. "Bayesian Performance Evaluation," NBER Working Papers 7069, National Bureau of Economic Research, Inc.
  22. Elton, Edwin J & Gruber, Martin J & Blake, Christopher R, 1996. "The Persistence of Risk-Adjusted Mutual Fund Performance," The Journal of Business, University of Chicago Press, vol. 69(2), pages 133-57, April.
  23. Russ Wermers, 2000. "Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses," Journal of Finance, American Finance Association, American Finance Association, vol. 55(4), pages 1655-1703, 08.
  24. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, Elsevier, vol. 33(1), pages 3-56, February.
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  27. Klaas P. Baks, 2001. "Should Investors Avoid All Actively Managed Mutual Funds? A Study in Bayesian Performance Evaluation," Journal of Finance, American Finance Association, American Finance Association, vol. 56(1), pages 45-85, 02.
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