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Getting your money's worth?
When we buy an actively managed fund, we are like gamblers in Vegas. We know it is likely to be a losing proposition, yet somehow we feel we are getting our money's worth.
-The Wall Street Journal, February 27, 2001
The quotation from The Wall Street journal highlights both investors' and gamblers' psychology in their attempt to maximize the returns attributable to their respective activities. Its implication is that both agents are rational with respect to the likely outcome an acceptance of the economic and statistical laws that ensure the strategy cannot be successful for all participants.
Gruber [1996] highlights the apparent puzzle surrounding the growth in actively managed mutual funds and the direction of significant mutual fund flows into the sector. The Investment Company Institute reports significant growth in US. stock mutual funds over the last calendar year. Net new cash flows increased to a record $309 billion as of December 2000, and the vast majority of net new money was allocated to active funds.
This preference in favor of active funds has continued despite considerable empirical evidence indicating active funds do not earn abnormal returns. While Zheng [1999] documents evidence of a "smart money" effect in the short term, in that new money flows predict future performance, in aggregate, active funds with positive new money flows do not beat the market. In addition, despite the documentation of performance persistence, Carhart [1997] finds the phenomenon is almost completely attributable to common factors in stock returns and investment expenses rather than superior portfolio management ability.
Investor allocation of capital to active funds appears to make little economic sense, especially when one considers the definition of a benchmark index and the implications an index has for performance measurement. Sharpe [1991] asserts that, on average, active managers cannot better the returns derived from passive investment strategies. The reasoning is that the performance of the index equals the weighted-average return of both active and passive investors before investment expenses. Therefore, by definition active management is a zero-sum game.1
Despite the significant attention to active funds in the performance evaluation literature, empirical research evaluating index funds is surprisingly scarce. This is even stranger when one considers that US. stock index mutual funds...