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| Research Paper 100 | |
| | Mutual Fund Flows and Performance in Rational Markets
Winner
of the 2003 FAME Research Prize
Authors
Jonathan
B. BERK - Haas School of Business, University of California, Berkeley
Richard
C. GREEN
- Graduate School of Industrial Administration, Carnegie Mellon University
Date
December
2002
Click here to download a .pdf of this paper
(1'347 KB).
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. 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 actively managed 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 flow of
funds exists in our model: indeed, this is the market mechanism that ensures that no predictability
in performance exists. Choosing parameters to match the flow-performance relationship and survivorship
rates, we find 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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