How Efficiently Do Investors Allocate Capital to Active Mutual Funds?

Abstract

I show that investors misallocate a substantial amount of capital in the active mutual fund industry. To this end, I develop a novel structural identification strategy to estimate the returns to scale in active management and the time-varying fund skills. A median fund is over-allocated by $29 million, so the majority of funds are expected to underperform. The industry can host more capital, but additional capital should go to a small fraction of funds. In particular, funds with the highest skills are severely under-allocated and account for most of the missing capital. In the time-series, under-allocated funds can outperform their benchmarks for three years. My findings suggest the active mutual fund industry is not always in a frictionless rational expectations equilibrium. The disequilibrium implies the existence of profit opportunities to informed investors and thus rationalizes the popularity of active management.

Keywords: Active Management, Mutual Fund, Returns to Scale, Skill, Capital Misallocation

JEL Classification: G11, G20, G23