Should smart investors buy funds with high returns in the past ? ¤ Frederic Palomino

Newspapers and weekly magazines catering to the investing crowd often rank funds according to the returns generated in the past. Aside from satisfying sheer curiosity, these numbers are probably also the basis on which investors pick a fund to invest in. In this article, we fully characterize the equilibrium in a game between a mutual fund manager of unknown ability who controls the riskiness of his portfolio and investors who only observe realized returns. We derive conditions under which (i) investors invest in the fund if the realized return falls within some interval, i.e., is neither too low nor too high, (ii) a good mutual fund manager picks a portfolio of minimal riskiness and (iii) a bad mutual fund manager will pick a portfolio with higher risk, \gambling" on a lucky outcome. We also show that regulating the maximum risk a mutual fund is allowed to take may actually decrease rather than increase the expected return to investors, even if the market price of risk is zero: the regulation ends up forcing the investor to pick the bad fund more often.