We develop a simple rational model of active portfolio management that provides a natural benchmark against which to evaluate observed relationship between returns and fund flows. Many effects widely regarded as anomalous are consistent with this simple explanation. In the model, investments with active managers do not outperform passive benchmarks because of the competitive market for capital provision, combined with decreasing returns to scale in active portfolio management. Consequently, past performance cannot be used to predict future returns, or to infer the average skill level of active managers. The lack of persistence in actively managed returns does not imply that differential ability across managers is nonexistent or unrewarded, that gathering information about performance is socially wasteful, or that chasing performance is pointless. A strong relationship between past performance and the flow of funds exists in our model: indeed, this is the market mechanism that ensures that no predictability in performance exists. Choosing parameters to match the flow-performance relationship and survivorship rates, we find these features of the data are consistent with the vast majority (80%) of active managers having at least

This paper solves the dynamic investment problem of a risk averse manager compensated with a call option on the assets he controls. Under the manager’s optimal policy, the option ends up either deep in or deep out of the money. As the asset value goes to zero, volatility goes to infinity. However, the option compensation does not strictly lead to greater risk seeking. Sometimes, the manager’s optimal volatility is less with the option than it would be if he were trading his own account. Furthermore, giving the manager more options causes him to reduce volatility. MANAGERS WITH CONVEX COMPENSATION SCHEMES play an important role in financial markets. This paper solves for the optimal dynamic investment policy for a risk averse manager paid with a call option on the assets he controls. The paper focuses on how the option compensation impacts the manager’s appetite for risk when he cannot hedge the option position. On one hand, the convexity of the option makes the manager shun payoffs that are likely to be near the money. Under the optimal policy, the manager

We document strong positive correlation between changes in institutional ownership and returns measured over the same period. The result suggests that either institutional investors positive feedback trade more than individual investors or institutional herding impacts prices more than herding by individual investors. We find evidence that both factors play a role in explaining the relation. We find no evidence, however, of return mean-reversion in the year following large changes in institutional ownership -- stocks institutional investors purchase subsequently outperform those they sell. Moreover, institutional herding is positively correlated with lag returns and appears to be related to stock return momentum. 1 "Herding" (a group of investors trading in the same direction over a period of time) and "feedback trading" (correlation between herding and lag returns) have the potential to explain a number of financial phenomena, e.g., excess volatility, momentum, and reversals in stoc...

This paper investigates the performance and capital inflows of private equity partnerships. Average fund returns (net of fees) approximately equal the S&P 500 although there is substantial heterogeneity across funds. Returns persist strongly across different funds raised by a partnership. Better performing partnerships are more likely to raise follow-on funds and larger funds. This relationship is concave so that top performing partnerships grow proportionally less than average performing partnerships. At the industry level, market entry and fund performance is cyclical; however, established funds are less sensitive to cycles than new entrants. Several of these results differ markedly from those for mutual funds.

We investigate the effect of scale on performance in the active money management industry. We first document that fund returns, both before and after fees and expenses, decline with lagged fund size, even after adjusting these returns by various performance benchmarks. We then explore a number of potential explanations for this relationship. We find that this relationship is most pronounced among funds that have to invest in small and illiquid stocks, which suggests that the adverse effects of scale are related to liquidity. Controlling for its size, a fund’s performance actually increases with the asset base of the other funds in the family that the fund belongs to. This suggests that scale need not be bad for fund returns depending on how the fund is organized. Finally, we explore the idea that scale erodes fund performance because of the interaction of liquidity and organizational diseconomies.

Mutual fund managers may decide to deviate from a well-diversified portfolio and con-centrate their holdings in industries where they have informational advantages. In this paper, we study the relation between the industry concentration and the perfor-mance of actively managed U.S. mutual funds from 1984 to 1999. Our results indicate that, on average, more concentrated funds perform better after controlling for risk and style differences using various performance measures. This finding suggests that investment ability is more evident among managers who hold portfolios concentrated in a few industries. ACTIVELY MANAGED MUTUAL FUNDS are an important constituent of the financial sector. Despite the well-documented evidence that, on average, actively man-aged funds underperform passive benchmarks, mutual fund managers might still differ substantially in their investment abilities.1 In this paper, we exam-ine whether some fund managers create value by concentrating their portfolios in industries where they have informational advantages.

We investigate the role that non-portfolio fund differentiation and information/search frictions play in creating two salient features of the mutual fund industry: the large number of funds and the sizeable dispersion in fund fees. In a case study, we find that despite the financial homogeneity of S&P 500 index funds, this sector exhibits the fund proliferation and fee dispersion observed in the broader industry. We show how extra-portfolio mechanisms explain these features. These mechanisms also suggest an explanation for the puzzling late-1990s shift in sector assets to more expensive (and often newly entered) funds: an influx of high-information-cost novice investors. * Zvi Eckstein and Alan Sorensen provided thoughtful suggestions regarding earlier drafts. We also thank Judith

Due to differences in financial sophistication and agency relationships, we posit that investors use different criteria to select portfolio managers in the retail mutual fund and fiduciary pension fund industry segments. We provide evidence on investors ’ manager selection criteria by estimating the relation between manager asset flow and performance. We find that pension fund clients use quantitatively sophisticated measures like Jensen’s alpha, tracking error, and outperformance of a market benchmark. Pension clients also punish poorly performing managers by withdrawing assets under management. In contrast, mutual fund investors use raw return performance and flock disproportionately to recent winners, but do not withdraw assets from recent losers. Mutual fund manager flow is significantly positively related to Jensen’s alpha, a seemingly anomalous result in light of a relatively unsophisticated mutual fund client base. We provide evidence, however, suggesting that this relation is driven by a high correlation between

This paper finds a positive, concave relation between the returns and share re-strictions of private investment funds, and shows that previously documented positive alphas can be interpreted as compensation for holding illiquid fund shares. The an-nual returns on funds with lockup provisions are approximately 4 % higher than those for non-lockup funds, and the alphas of funds with the most liquid shares are either negative or insignificant. This paper also finds a positive association between share restrictions and illiquidity in fund assets, suggesting that funds facing high redemption costs use restrictions to screen for investors with low-liquidity needs. The results are consistent with previous theories which posit that liquidity is priced, and that less liquid assets are held by investors with longer investment horizons. JEL classification: G11; G12

We review extensive evidence about how psychological biases affect investor behavior and prices. Systematic mispricing probably causes substantial resource misallocation. We argue that limited attention and overconfidence cause investor credulity about the strategic incentives of informed market participants. However, individuals as political participants remain subject to the biases and self-interest they exhibit in private settings. Indeed, correcting contemporaneous market pricing errors is probably not government’s relative advantage. Government and private planners should establish rules ex ante to improve choices and efficiency, including disclosure, reporting, advertising, and default-option-setting regulations. Especially