53 Pages Posted: 18 Jan 2017 Last revised: 22 Nov 2017
Date Written: November 18, 2017
Mutual funds are one of the most popular investment vehicles, although many investors receive negative excess returns on their investments. We develop a model in which mutual fund investors chase CAPM alpha. Managers can generate CAPM alpha either by discovering mispricing -- True Alpha -- or by loading on risk factors that are beyond the scope of the CAPM -- Fake Alpha. Investors cannot distinguish between the two different types of alpha and thus, confuse Fake Alpha with True Alpha. Within the model, we show that their delusion ex-post causes negative CAPM alpha in equilibrium states. Our theory is empirically confirmed by an analysis of the US equity actively managed mutual fund universe. We identify equilibrium states and find that the average CAPM alpha in these states is significantly negative. Among the group of retail investors, we observe that funds with relatively large loads of Fake Alpha provide significantly lower CAPM alpha to investors than their peers. Linking empirical results with our model leads us to conclude that the retail active management industry is roughly too large by factor three.
Keywords: mutual funds, active management, managerial skill, alpha
JEL Classification: G11, G20, G23
Suggested Citation: Suggested Citation