Mutual Fund Flows and Performance in Rational Markets

38 Pages Posted: 11 Oct 2002  

Richard C. Green

Carnegie Mellon University - David A. Tepper School of Business

Jonathan Berk

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: October 2002

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. We show that 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 active manager 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 ow of funds exists in our model, indeed this is the market mechanism that ensures that no predictability in performance exists. Calibrating the model to the fund flows 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.

Suggested Citation

Green, Richard C. and Berk, Jonathan, Mutual Fund Flows and Performance in Rational Markets (October 2002). NBER Working Paper No. w9275. Available at SSRN: https://ssrn.com/abstract=338881

Richard C. Green

Carnegie Mellon University - David A. Tepper School of Business ( email )

315B Schenley Park
Pittsburgh, PA 15213-3890
United States
412-268-2302 (Phone)
412-268-7064 (Fax)

Jonathan B. Berk (Contact Author)

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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