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Should smart investors buy funds with high returns in the past

Author

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  • Palomino, F.A.

    (Tilburg University, Center For Economic Research)

  • Uhlig, H.F.H.V.S.

    (Tilburg University, Center For Economic Research)

Abstract

Newspapers and weekly magazines catering to the investing crowd often rank funds according to the returns generated in the past. Aside from satisfying sheer curiosity, these numbers are probably also the basis on which investors pick a fund to invest in. In this article, we fully characterize the equilibrium in a game between a mutual fund manager of unknown ability who controls the riskiness of his portfolio and investors who only observe realized returns. We derive conditions under which (i) investors invest in the fund if the realized return falls within some interval, ie., is neither too low nor too high, (ii) an informed fund manager picks a portfolio of minimal riskiness, (iii) an uninformed mutual fund manager will pick a portfolio with higher risk, ‘gambling’ on a lucky outcome and (iv), when the fee structure is endogenous, both types of manager choose the same fraction-of-fund fee structure. Our results are consistent with empirical evidence about the lack of persistence of top performance, and about the very wide use of fraction-of-fund fee structure among mutual funds.
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Suggested Citation

  • Palomino, F.A. & Uhlig, H.F.H.V.S., 1999. "Should smart investors buy funds with high returns in the past," Discussion Paper 1999-69, Tilburg University, Center for Economic Research.
  • Handle: RePEc:tiu:tiucen:6fa9174d-5b50-47fe-9f84-8a73d6dd2568
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    References listed on IDEAS

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    1. Grinblatt, Mark & Titman, Sheridan, 1993. "Performance Measurement without Benchmarks: An Examination of Mutual Fund Returns," The Journal of Business, University of Chicago Press, vol. 66(1), pages 47-68, January.
    2. 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.
    3. Brown, Stephen J & Goetzmann, William N, 1995. " Performance Persistence," Journal of Finance, American Finance Association, vol. 50(2), pages 679-698, June.
    4. Chevalier, Judith & Ellison, Glenn, 1997. "Risk Taking by Mutual Funds as a Response to Incentives," Journal of Political Economy, University of Chicago Press, vol. 105(6), pages 1167-1200, December.
    5. In-Koo Cho & David M. Kreps, 1987. "Signaling Games and Stable Equilibria," The Quarterly Journal of Economics, Oxford University Press, vol. 102(2), pages 179-221.
    6. David K. Musto, 1999. "Investment Decisions Depend on Portfolio Disclosures," Journal of Finance, American Finance Association, vol. 54(3), pages 935-952, June.
    7. Khorana, Ajay, 1996. "Top management turnover An empirical investigation of mutual fund managers," Journal of Financial Economics, Elsevier, vol. 40(3), pages 403-427, March.
    8. Goriaev, A.P. & Palomino, F.A. & Prat, A., 2000. "Mutual Fund Tournament : Risk Taking Incentives Induced by Ranking Objectives," Discussion Paper 2000-94, Tilburg University, Center for Economic Research.
    9. 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.
    10. Palomino, F.A. & Prat, A., 1998. "Dynamic incentives in the money management tournament," Discussion Paper 1998-107, Tilburg University, Center for Economic Research.
    11. Heinkel, Robert & Stoughton, Neal M, 1994. "The Dynamics of Portfolio Management Contracts," Review of Financial Studies, Society for Financial Studies, vol. 7(2), pages 351-387.
    12. Crawford, Vincent P & Sobel, Joel, 1982. "Strategic Information Transmission," Econometrica, Econometric Society, vol. 50(6), pages 1431-1451, November.
    13. Golec, Joseph H., 1992. "Empirical Tests of a Principal-Agent Model of the Investor-Investment Advisor Relationship," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 27(01), pages 81-95, March.
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    Cited by:

    1. Goriaev, A.P., 2002. "On the behavior of mutual fund investors and managers," Other publications TiSEM 2024249e-ce62-4693-bc8d-4, Tilburg University, School of Economics and Management.

    More about this item

    Keywords

    investment; return on investment;

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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