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Should Investors Avoid All Actively Managed Mutual Funds? A Study in Bayesian Performance Evaluation

Authors

  • Klaas P. Baks,

  • Andrew Metrick,

  • Jessica Wachter

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    • Baks and Metrick are from the Department of Finance, The Wharton School, University of Pennsylvania. Wachter is from the Department of Finance, The Stern School, New York University. We thank Nick Barberis, Gary Chamberlain, Ken French, Will Goetzmann, Karsten Hansen, Chris Jones, Tom Knox, Tony Lancaster, L̆ubos̆ Pástor, André Perold, Steve Ross, Andrei Shleifer, Rob Stambaugh, René Stulz, Sheridan Titman, an anonymous referee, and seminar participants at Columbia, Wharton, the NBER, the 1999 NBER Summer Institute, and the 2000 AFA meetings for helpful comments. Wachter thanks Lehman Brothers for financial support.

ABSTRACT

This paper analyzes mutual-fund performance from an investor's perspective. We study the portfolio-choice problem for a mean-variance investor choosing among a risk-free asset, index funds, and actively managed mutual funds. To solve this problem, we employ a Bayesian method of performance evaluation; a key innovation in our approach is the development of a flexible set of prior beliefs about managerial skill. We then apply our methodology to a sample of 1,437 mutual funds. We find that some extremely skeptical prior beliefs nevertheless lead to economically significant allocations to active managers.

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