The Portfolio Allocation Effects of Investor Confidence in Managers

I present a model that can transform discounts on closed-end mutual funds into a measure of investor sentiment about the ability of fund managers to beat the market. It is demonstrated that this measure of sentiment varies positively with capital flows into open-end mutual funds, which are actively managed, and negatively with capital flows into index funds, which are passively managed. This is consistent with the hypothesis that investors re-allocate their portfolios between actively and passively managed investment vehicles based on expectations as to whether active management is likely to beat the market. ∗Department of Economics, Vassar College, 124 Raymond Ave. #424, Poughkeepsie, NY 12604. [email protected] I would like to thank George Akerlof for encouragement and numerous suggestions, J. Bradford DeLong for guiding me to the study of closed-end funds, and David Romer, Greg Duffee, David Freedman, Richard Lyons, and Roger Craine for numerous comments and suggestions.