Mutual Fund Management: Does Active Management Pay?

Recent studies have documented a positive relation between active management and mutual fund performance. We show that this relation holds only for fund managers who trade in an optimal way. The optimality measure that we develop, “investment alpha”, captures whether a mutual fund is trading towards mean-variance optimality, which, we argue, is the first best choice for mutual fund managers. This investment alpha is similar to previous work using evaluation alphas such as Jensen’s alpha, except that our benchmark is the manager’s own portfolio. We show that if the investment alpha of a fund’s incremental portfolio — defined as the portfolio obtained by collecting the changes in a manager’s positions over a given period — is positive then the fund is trading in the right direction. We show empirically that managers who did so outperformed, and the more so if they were more active (in the right direction), and that investors react to the correct direction through increases in fund flows in the subsequent quarter. Active managers that traded in the wrong direction did not outperform. ∗University of Utah, [email protected]. I thank Peter Bossaerts, Michael Cooper, Michael Halling, Elena Asparouhova, Feng Zhang, Yihui Pan, and Davidson Heath for great advice and guidance for this project. The paper also benefited a lot from multiple discussions with Hank Bessembinder. Special thanks to the Luke Taylor and Lubos Pastor for sharing their data.