News — Extensive research has shown that actively managed mutual funds perform no better than index funds and their past performance is no indicator of future returns. So then why do investors continue to comb through records in search for the top mutual fund?
Many researchers have chalked up the answer to irrational behavior, but not Jonathan Berk, an associate professor of finance at UC Berkeley's Haas School of Business. In an article that recently won an award on scholarly writing from the financial services firm TIAA-CREF, Berk concluded that such behavior makes sense. In the winning article "Mutual Fund Flows and Performance in Rational Markets," (Journal of Political Economy, December 2004), Berk and co-author Richard C. Green of Carnegie Mellon University found that some mutual fund managers are talented enough to beat the market when their fund is small. But as more investors become aware of their skills, their funds grow and their performance deteriorates. That's because as funds grow larger, managers receive poor prices when buying and selling larger blocks of stock, and it's also more difficult to manage more stocks in a portfolio, Berk explains. "People didn't understand why money flowed to mutual fund managers that did well because if you look at the data, the past is no predictor that the fund would do well in the future." Berk says. "But it's the other way around: The reason why mutual fund returns are unpredictable is precisely because of the flow of funds from investors."
So what's an investor to do? "Stick with index funds," Berk says. "That is, unless an investor has a competitive advantage for finding a good fund manager."
Berk's mutual fund research was one of two articles to recently win the 2005 TIAA-CREF Paul A. Samuelson Award for Outstanding Scholarly Writing on Lifelong Financial Security.
Berk has made a practice of explaining seemingly puzzling relationships in finance. In another paper just named one of the two best articles ever published in the Review for Financial Studies, Berk tackled the "size anomaly" " why smaller firms' stocks tend to deliver higher average returns.
In that article, "A Critique of Size-Related Anomalies," Berk provided a theoretical explanation for the inverse relationship between firm size and risk " or why smaller firms tend to be riskier investments and consequently yield higher returns. He then showed why the relationship between small firms' stock and higher returns should not be viewed as an anomaly.
Berk notes that one example of the size anomaly can be found in the mutual fund world, where funds that invest in smaller companies typically outperform those that focus on larger firms.
To access Berk's article "Mutual Fund Flows and Performance in Rational Markets," visit:.
To access Berk's article "A Critique of Size-Related Anomalies," visit: .
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