Why do investors buy shares of actively managed equity mutual funds? Considering the Correct Reference Portfolio from an Uninformed Investor's Perspective 1, 2

TL;DR

This paper develops a new reference portfolio for uninformed investors to evaluate actively managed equity mutual funds, showing that these funds provide minimal or negative alpha when compared to this benchmark, supporting their value for uninformed investors.

Contribution

It introduces an empirical methodology to construct a reference portfolio based on prices and supply, assessing fund performance from an uninformed investor's perspective.

Findings

Mutual funds offer an insignificant alpha of 23 basis points per year against the reference portfolio.

Using the market index as a proxy, the average fund alpha is significantly negative at -128 basis points per year.

Results are consistent across various fund subsets and levels of selectivity.

Abstract

We use the Grossman \& Stiglitz (1980) framework to build a reference portfolio for uninformed investors and employ this portfolio to assess the performance of actively managed equity mutual funds. We propose an empirical methodology to construct this reference portfolio using the information on prices and supply. We show that mutual funds provide, on average, an insignificant alpha of 23 basis points per year when considering this portfolio as a reference. With the stock market index as a proxy for the market portfolio, the average fund alpha is negative and highly significant, --128 basis points per year. The results are robust when considering various subsets of funds based on their characteristics and their degree of selectivity. In line with rational expectations equilibrium models considering asymmetrically informed investors and partially revealing equilibrium prices, our study supports that active management adds value for uniformed investors.