Are Subjective Expectations Formed as in Rational Expectations Models of Active Management?

Abstract

We recover forward-looking expected net-of-fee abnormal returns (alphas) for active equity mutual funds from analyst ratings. In contrast to the typical equilibrium implication of zero alphas, analyst alphas are negative for most funds, but positive for the largest funds. We compare analysts' subjective expectations with expectations from a rational expectations learning model. The model's rational learner believes that an increase in fund size leads to a decrease in returns, but we find no evidence that analysts believe so. Overall, analysts' expectations and the capital that follows analysts' recommendations are difficult to reconcile with existing rational expectations models of active management.

Keywords: Alpha, expectations formation, mutual funds

JEL Classification: G11, G12, G14, G23