Why Mutual Funds 'Underperform'

Abstract:     
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.

Number of Pages in PDF File: 41

Keywords: Mutual Fund, Performance, Pricing Kernel, Business Cycle

JEL Classification: G23, G12, G11

Accepted Paper Series