Unobserved Actions of Mutual Funds
49 Pages Posted: 8 Feb 2006 Last revised: 27 Aug 2010
Date Written: November 2005
Despite extensive disclosure requirements, mutual fund investors do not observe all actions of fund managers. We estimate the impact of unobserved actions on fund returns using the return gap, which is defined as the difference between the reported fund return and the return of a portfolio that invests in the previously disclosed holdings after adjusting for expenses. Analyzing monthly return data on more than 2,500 unique U.S. equity funds over the period 1984-2003, we document a substantial cross-sectional heterogeneity and time-series persistence in the return gap, thus demonstrating that unobserved actions of some funds persistently create value, while such actions of others destroy value. Most important, we show that the return gap helps to predict future fund performance and conclude that fund investors should use the return gap as an additional measure to evaluate the performance of mutual funds.
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