Mutual Fund Flows and Performance in Rational Markets
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What they found
Berk and Green resolved an apparent contradiction: investors chase past fund performance, yet fund performance does not persist. Their model assumes some managers have genuine skill but that skill has decreasing returns to scale (a strategy earns less as more money is put into it). Investors rationally direct money to managers with good records, which grows the fund until its expected excess return to investors is competed down to zero. Skill exists and is captured by managers as fees, while investors earn nothing extra, and past performance does not predict future performance because the flows have already adjusted.
What you can use
- Lack of performance persistence does not mean managers have no skill; it means capital flows in until the skill is fully priced.
- Every strategy has a capacity; the better a strategy is known to be, the more money follows it and the smaller its returns become.
- Small, capacity-constrained edges are where retail traders can plausibly compete, because institutional capital cannot bother with them.
Caveats
A theoretical model; the assumption of decreasing returns to scale is supported by later evidence but debated in magnitude. Mathematical.
Tags: professional, mutual-funds, skill, capacity, theory
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.