Another Puzzle: The Growth in Actively Managed Mutual Funds



  • Stern School of Business, New York University. This article was prepared for the Presidential Address of the American Finance Association meetings in San Francisco, January 1996. I appreciate the research assistance of Jeffrey Busse and want to thank Yakov Amihud, Christopher Blake, Stephen Brown, Edwin Elton, and Gregory Udell for commenting on an earlier draft of this paper. I would also like to thank Bill Crawford and Lisa Simms of Micropal and Donald Cassidy of Lipper Analytical Services for providing me with some of the data used in this article.


Mutual funds represent one of the fastest growing type of financial intermediary in the American economy. The question remains as to why mutual funds and in particular actively managed mutual funds have grown so fast, when their performance on average has been inferior to that of index funds. One possible explanation of why investors buy actively managed open end funds lies in the fact that they are bought and sold at net asset value, and thus management ability may not be priced. If management ability exists and it is not included in the price of open end funds, then performance should be predictable. If performance is predictable and at least some investors are aware of this, then cash flows into and out of funds should be predictable by the very same metrics that predict performance. Finally, if predictors exist and at least some investors act on these predictors in investing in mutual funds, the return on new cash flows should be better than the average return for all investors in these funds. This article presents empirical evidence on all of these issues and shows that investors in actively managed mutual funds may have been more rational than we have assumed.