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Mutual Fund Performance and the Incentive to Generate Alpha

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  • Diane Del Guercio
  • Jonathan Reuter

Abstract

Financial economists have long been puzzled by investor demand for actively managed funds that generate, on average, negative after-fee, risk-adjusted returns. To shed new light on this puzzle, we exploit the fact that funds in different market segments compete for different types of retail investors. Within the segment of funds marketed directly to retail investors, we find that flows chase risk-adjusted returns, and that funds respond by investing more in active management. Importantly, within this direct-sold segment, we find little evidence that actively managed funds underperform index funds. In contrast, within the segment of funds sold through brokers, which we demonstrate face a weaker incentive to generate alpha, we find that actively managed funds significantly underperform index funds. We conclude that the well-known underperformance of the average actively managed fund in the full sample is driven by the large fraction of funds with weak incentives to identify and motivate skilled managers.

Suggested Citation

  • Diane Del Guercio & Jonathan Reuter, 2011. "Mutual Fund Performance and the Incentive to Generate Alpha," NBER Working Papers 17491, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:17491
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    More about this item

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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