Capital gravitates toward key profitable mutual funds until the marginal asset return equilibrates near the core stock market benchmark.

Peter Prince

2019-07-27 17:37:00 Sat ET

Capital gravitates toward key profitable mutual funds until the marginal asset return equilibrates near the core stock market benchmark. As Stanford finance professor Jonathan Berk suggests, capital flows equilibrate persistent mutual fund returns relative to the stock market benchmarks. Since investors first direct capital to the best active mutual fund managers, these fund managers receive so much money that it affects their ability to generate superior returns. The average return declines to fit the average return for the second-best fund managers. At this stage, investors become indifferent to investing with the first-best and second-best fund managers, so capital flows equilibrate until their average return declines to match the average return for the third-best fund managers.

This process continues until the average return of investing in most active mutual funds declines to match the stock market benchmark. Capital flows can thus reflect persistent asset returns in the transition toward the dynamic equilibrium outcome. Only high-skill fund managers can consistently earn superior average returns when numerous fund managers compete for scarce capital flows. The rationale suggests that investors who choose to invest with active fund managers cannot expect to receive positive excess returns after we apply appropriate risk and fee adjustments.

 


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