Five Myths of Active Portfolio Manage- ment

1Jonathan B. Berk Haas School of Business University of California, Berkeley and National Bureau of Economic Research Email: [email protected] P roponents of “efficient markets” argue that it is impossible to consistently beat the market. In support of their view they point to the evidence that, as a group, active managers do not beat the market and conclude that even these investment professionals do not have the skills necessary to pick stocks or time the market. Yet, if that argument is correct, why do active portfolio managers exist at all? Even more puzzling is their level of compensation. One of the first principals any student of microeconomics learns is that in a competitive market (and one would be hard pressed to argue that the capital markets are not competitive) people can only earn economic rents if they have a skill in short supply. If active managers cannot pick stocks or time the market, what rare skill do they posses that places them among the highest paid members of society? Even people who allow for the possibility that some managers have skill have been hard pressed to find evidence of this skill in the data. Beyond a year there is little evidence of performance persistence — managers who do well in one year are no more likely to do well the following year. This fact is widely interpreted as evidence that the performance of the best managers is due entirely to luck rather than skill (and thus not repeatable). The behavior of investors is just as puzzling. Why do investors continue to invest with active managers in face of this evidence? Yet investors chase returns; a good year induces an inflow of funds and a bad year induces an outflow of funds. Thus, the flow of funds into and out of actively managed mutual funds is sensitive to past fund performance even though there is no strong evidence of persistence. My objective in this paper is to explain these facts and show they are consistent with a rational and competitive