Why mutual funds “underperform”☆

Abstract

I propose a parsimonious model that reproduces the negative risk-adjusted performance of actively managed equity mutual funds. In the model, a fund manager can generate state-dependent active returns at a disutility. Negative expected performance and mutual fund investing simultaneously arise in equilibrium because the active return the fund manager generates covaries positively with a component of the pricing kernel that the performance measure omits, consistent with recent empirical evidence. Using data on U.S. funds, I also document new empirical evidence consistent with the model's cross-sectional implications. Disciplines Finance | Finance and Financial ManagementThis journal article is available at ScholarlyCommonsAbstract I propose a parsimonious model that reproduces the negative risk-adjusted performance of actively managed mutual funds and the funds' high abnormal performance realized in bad states of the economy. In the model, a fund manager can generate state-dependent active returns at a disutility. Negative expected performance and mutual fund investing simultaneously arise in equilibrium because the fund's optimal active return covaries positively with a component of the pricing kernel that the performance measure omits. Using data on U.S. funds, I document empirical evidence consistent with the model's cross-sectional implications. JEL classification: G23; G12; G11.

Winners and losers: German equity mutual funds

“…It is therefore likely that persistently poor performance by some funds also requires an assumption of "frictions" in the ability to switch from poorly performing to potential winner funds. Other explanations of long-term negative performance include pure inertia, influences of broker and manager advertising and tax considerations (Gruber, 1996) or negative performance as a payoff for countercyclical performance (Glode, 2009) or that investors buy and sell actual index funds at the wrong time, and passive indices do not reflect this (Savov 2009 …”

Only Winners in Tough Times Repeat: Hedge Fund Performance Persistence over Different Market Conditions

“…We show that by using a conditional past performance measure to focus on time periods when information-to-noise ratio is high, we can obtain a much stronger performance forecasting power. Second, our paper contributes to the literature that examines time-varying asset return and fund performance predictability conditioning on market situations, including Ferson and Schadt (1996), Moskowitz (2000), Cooper, Gutierrez andHameed (2004), Fung, Hsieh, Naik, andRamadorai (2008), Glode (2011), Kosowski (2011), Kacperczyk, Van Nieuwerburgh, andVeldkamp (2013a, b), De Souza and Lynch (2012), Glode, Hollifield, Kacperczyk, and Kogan (2012). In particular, Cooper, Gutierrez and Hameed (2004) and Glode, Hollifield, Kacperczyk, and Kogan (2012) study return persistence for stocks and mutual funds, respectively, and find stronger persistence following periods of strong markets.…”

Active Management and Price Efficiency of Exchange-traded Funds

“…Savov (2009) builds a noisy rational expectations model with wealth shocks to show that active funds and index funds are equally attractive as long as time-varying exposure is considered. Another model proposed by Glode (2011) also documents the active funds' signifi cant better realized performance in bad states of the economy than in good states. Pastor and Stambaugh (2012) rationalize this puzzle by the impact of slow Bayesian updating.…”