Mutual Fund Flows and Performance in Rational Markets
Abstract
We develop a simple rational model of active portfolio management that provides a natural benchmark against which to evaluate observed relationship between returns and fund flows. We show that many effects widely regarded as anomalous are consistent with this simple explanation. In the model, investments with active managers do not outperform passive benchmarks because of the competitive market for capital provision, combined with decreasing returns to scale in active portfolio management. Consequently, past performance cannot be used to predict future returns, or to infer the average skill level of active managers. The lack of persistence in active manager returns does not imply that differential ability across managers is nonexistent or unrewarded, that gathering information about performance is socially wasteful, or that chasing performance is pointless. A strong relationship between past performance and the ow of funds exists in our model, indeed this is the market mechanism that ensures that no predictability in performance exists. Calibrating the model to the fund flows and survivorship rates, we find these features of the data are consistent with the vast majority (80%) of active managers having at least enough skill to make back their fees.
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If the market was largely comprised of investors who solely maximized profits, they would undo the effects of investors with a preference for sustainability, resulting in zero net flows.
“If the market was largely comprised of the investors of Berk and Green (2004) who solely maximized prots, these investors who did not value sustainability would undo the eects of investors with a preference for sustainability, resulting in zero net ows.”
From Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows (2019) · cites this paper as Berk and Green 2004
The Introduction (page unavailable) describes a model of rational, self-interested investors, and §2 explains that their fund flows compete away expected excess returns. The paper does not address sustainability preferences or say that profit-seeking investors would offset sustainability-driven investment to produce zero net flows. Its zero refers to expected excess returns, not flows. (LLM, conf=0.84)
Experimental — accuracy not yet measuredIf a small subset of investors had strong preferences for sustainability while most investors did not directly value sustainability, under standard models there would be no effect of the ratings on net flows.
“If a small subset of investors had strong preferences for sustainability while most investors did not directly value sustainability, under standard models (e.g.Berk and Green 2004) we would not nd an eect of the ratings on net ows.”
From Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows (2019) · cites this paper as Berk and Green 2004
Section 3, “The Model,” describes fund flows responding to expected excess returns, supporting the citation as an example of a rational fund-flow model. It does not consider sustainability ratings or investors with differing sustainability preferences, so it does not establish that ratings would have no effect on net flows in the stated scenario. (LLM, conf=0.82)
Experimental — accuracy not yet measuredFunds have decreasing returns to scale.
“Berk and Green (2004) assume that funds have decreasing returns to scale which is empirically supported by the ndings of Grinblatt and Titman (1989), Chen et al. (2004), Pástor et al. (2015) (though Reuter and Zitzewitz (2010) do not nd such an eect).”
From Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows (2019) · cites this paper as Berk and Green (2004)
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“Because the average fee does not differ by much across deciles, it is investors that determine these compensation differences (by choosing to allocate their capital to skilled managers), confirming a central insight in Berk and Green (2004).”
BackgroundResultInfluentialSelf-citationMutual Fund Attributes and Investor Behavior
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“…that some fund managers may be able to exploit on a consistent basis to generate superior returns.1 Ippolito (1992), Lynch and Musto (2003), and Berk and Green (2004), among others, interpret the flow-performance relation as a reflection of investors 1For examples of stock market anomalies,…”
BackgroundInfluentialPayoff complementarities and financial fragility: Evidence from mutual fund outflows
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“Second, according to Berk and Green (2004), the lack of persistence in the returns of open-end funds might not be indicative of the lack of persistence in the quality of the managers because the response of flow to performance affects future performance when there are decreasing returns to scale in asset management.”
BackgroundInfluentialThe Economics of Private Equity Funds
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Self-citationParticipation Costs and the Sensitivity of Fund Flows to Past Performance
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“This independence result and the fact that holdings are linear and increasing in past performance are common to CARA-normal models with learning about managerial ability; see, for example, Berk and Green (2004) and Lynch and Musto (2003).”
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“Our finding of no improvement in fund returns remain unchanged when we add log(Fund Size) to control for diseconomies of scale (Berk and Green 2004), and when we use Fund Return as an alternative dependent variable.”
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The Interim Trading Skills of Institutional Investors
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The Determinants of Mutual Fund Performance: A Cross-Country Study
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“Large funds, however, face some problems and management challenges and the scaleability of investments is determinant for the persistence of fund performance (e.g. Gruber (1996) and Berk and Green (2004)).”
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How Does Size Affect Mutual Fund Behavior?
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Mutual Fund Performance and the Incentive to Generate Alpha
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“First, another way to account for nonlinearities in the ow-performance relations is suggested by Berk and Green (2004), whose model of fund ows in a fully rational world with symmetric information implies that the optimal relation between ows and risk-adjusted returns is quadratic over a wide range.”
MethodIndexing and active fund management: International evidence
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“Berk and Green (2004) and Pastor and Stambaugh (2012) argue that fund managers can have skill and investors invest in”
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“Berk and Green (2004) show that these facts are consistent with rational learning.”
BackgroundDecentralized Mining in Centralized Pools
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“%) of active managers having at least enough skills to cover their fees (Berk & Green 2004).”
BackgroundResultOn the Industry Concentration of Actively Managed Equity Mutual Funds
Kacperczyk, M. T., Sialm, C., & Zheng, L. (2004) · National Bureau of Economic Research · doi:10.3386/w10770 · Cited by 326 · see citing works
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“More recently, Berk and Green (2004) develop a rational model of active fund management.”
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“This is because it will determine the degree to which fund size is affected by past performance which conditions how a fund performs in the future (Berk and Green (2004)).”
InfluentialDo Hot Hands Exist among Hedge Fund Managers? An Empirical Evaluation
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Optimal Asset Allocation and Risk Shifting in Money Management
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Information and Incentives Inside the Firm: Evidence from Loan Officer Rotation
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“In line with Berk and Green (2004), we expect that in equilibrium more assets are assigned to loan o¢ cers with higher perceived ability.”
BackgroundInfluentialBusiness Networks, Corporate Governance, and Contracting in the Mutual Fund Industry
Kuhnen, C. M. (2009) · The Journal of Finance · doi:10.1111/j.1540-6261.2009.01498.x · Cited by 251 · see citing works
Institutional investors and the limits of arbitrage
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“For example, it supports Berk and Green’s (2004) contention that many stylized facts about mutual fund performance and flows are consistent with a rational, competitive mutual fund industry.”
BackgroundDo Private Equity Fund Managers Earn Their Fees? Compensation, Ownership, and Cash Flow Performance
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UK mutual fund performance: Skill or luck?
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WSJ Category Kings - The Impact of Media Attention on Consumer and Mutual Fund Investment Decisions
Kaniel, R., & Parham, R. (2015) · Journal of Financial Economics · doi:10.1016/j.jfineco.2016.11.003 · Cited by 233 · see citing works
Teo, M. (2009) · Review of Financial Studies · doi:10.1093/rfs/hhp007 · Cited by 228 · see citing works
“However, the decreasing returns to scale argument advanced in Goetzmann, Ingersoll, and Ross (2003), Berk and Green (2004), and Fung, Hsieh, Naik, and Ramadorai (2006) may apply”
What Matters to Individual Investors? Evidence from the Horse's Mouth
Choi, J. J., & Robertson, A. (2020) · The Journal of Finance · doi:10.1111/jofi.12895 · Cited by 231 · see citing works
“Regarding the assumptions of Berk and Green (2004), 46% of respondents agree or strongly agree that past returns are evidence of skill, but only 18% agree or strongly agree that there are decreasing returns to scale in active money management.”
InfluentialThe liquidity risk of liquid hedge funds
Teo, M. (2010) · Journal of Financial Economics · doi:10.1016/j.jfineco.2010.11.003 · Cited by 221 · see citing works
“19 The counter argument is that investors are smart but due to the diseconomies of scale envisaged by Berk and Green (2004), inflows only predict returns in the short term.”
BackgroundInfluentialDo Funds Make More When They Trade More?
Pástor, Ľ., Stambaugh, R. F., & Taylor, L. A. (2014) · The Journal of Finance · doi:10.1111/jofi.12509 · Cited by 228 · see citing works
The Road Less Traveled: Strategy Distinctiveness and Hedge Fund Performance
Sun, Z., Wang, A., & Lu, Z. K. (2011) · Review of Financial Studies · doi:10.1093/rfs/hhr092 · Cited by 234 · see citing works
“AUM is negatively associated with the future alpha, consistent with the notion of performance erosion due to increased scale in the mutual fund sector, as discussed in Berk and Green (2004) and Chen, Hong, Huang, and Kubik (2004).”
InfluentialDo Investment Banks Matter for M&A Returns?
Bao, J., & Edmans, A. (2011) · Review of Financial Studies · doi:10.1093/rfs/hhr014 · Cited by 226 · see citing works
“We refute this hypothesis by showing that the banks with the lowest average returns are not the most frequent advisors – the correlation between bank fixed effects and market share is an insignificant 0.03 (p-value of 0.72).”
InfluentialChan, N. T., Getmansky, M., Haas, S. M., & Lo, A. W. (2005) · National Bureau of Economic Research · doi:10.3386/w11200 · Cited by 224 · see citing works
Market impact and trading profile of hidden orders in stock markets
Moro, E., Vicente, J., Moyano, L. G., Gerig, A., Farmer, J. D., Vaglica, G., Lillo, F., & Mantegna, R. N. (2009) · Physical Review E · doi:10.1103/physreve.80.066102 · Cited by 220 · see citing works
Portfolio Manager Compensation in the U.S. Mutual Fund Industry
Ma, L., Tang, Y., & Gómez, J.-P. (2018) · The Journal of Finance · doi:10.1111/jofi.12749 · Cited by 230 · see citing works
Defined Contribution Pension Plans: Sticky or Discerning Money?
Sialm, C., Starks, L. T., & Zhang, H. (2014) · The Journal of Finance · doi:10.1111/jofi.12232 · Cited by 213 · see citing works
Sex Matters: Gender Bias in the Mutual Fund Industry
Niessen‐Ruenzi, A., & Ruenzi, S. (2018) · Management Science · doi:10.1287/mnsc.2017.2939 · Cited by 201 · see citing works
Conditional Return Smoothing in the Hedge Fund Industry
Bollen, N. P. B., & Pool, V. K. (2008) · Journal of Financial and Quantitative Analysis · doi:10.1017/s0022109000003525 · Cited by 186 · see citing works
“In the spirit of Berk and Green (2004), it would be rational for investors with more diffuse prior beliefs of managerial ability to respond more quickly to performance. Investors with short or unpredictable investment horizons are undesirable from a hedge fund manager’s perspective, as they may limit her ability to ex…”
BackgroundInfluentialManagerial Ability, Compensation, and the Closed‐End Fund Discount
Berk, J., & Stanton, R. (2007) · The Journal of Finance · doi:10.1111/j.1540-6261.2007.01216.x · Cited by 194 · see citing works
Self-citationOn the Size of the Active Management Industry
Pástor, L., & Stambaugh, R. F. (2012) · Journal of Political Economy · doi:10.1086/667987 · Cited by 236 · see citing works
Pay for Performance from Future Fund Flows: The Case of Private Equity
Chung, J., Sensoy, B. A., Stern, L. H., & Weisbach, M. S. (2012) · Review of Financial Studies · doi:10.1093/rfs/hhr141 · Cited by 202 · see citing works
Investing in Talents: Manager Characteristics and Hedge Fund Performances
Li, H., Zhang, X., & Zhao, R. Z. (2010) · Journal of Financial and Quantitative Analysis · doi:10.1017/s0022109010000748 · Cited by 202 · see citing works
Informational Holdup and Performance Persistence in Venture Capital
Hochberg, Y. V., Ljungqvist, A. P., & Vissing‐Jørgensen, A. (2013) · Review of Financial Studies · doi:10.1093/rfs/hht046 · Cited by 201 · see citing works
“This implies that the “return-chasing” behavior emphasized by Berk and Green (2004) as the mechanism eliminating performance persistence in mutual funds breaks down in the VC setting when there is asymmetric learning.”
InfluentialInstitutional Investors and Mutual Fund Governance: Evidence from Retail–Institutional Fund Twins
Evans, R. B., & Fahlenbrach, R. (2012) · Review of Financial Studies · doi:10.1093/rfs/hhs105 · Cited by 189 · see citing works
Smith, E. B. (2011) · Administrative Science Quarterly · doi:10.2189/asqu.2011.56.1.061 · Cited by 195 · see citing works
“In studies of mutual and hedge fund industries, for instance, research has shown that fund age significantly attenuates the association between fund returns and investor capital flows in both positive and negative directions (Chevalier and Ellison, 1997; Berk and Green, 2004).”
Learning About CEO Ability and Stock Return Volatility
Pan, Y., Wang, T. Y., & Weisbach, M. S. (2015) · Review of Financial Studies · doi:10.1093/rfs/hhv014 · Cited by 191 · see citing works
Efficiently Inefficient Markets for Assets and Asset Management
Garleanu, N. B., & Pedersen, L. H. (2015) · The Journal of Finance · doi:10.1111/jofi.12696 · Cited by 182 · see citing works
Does Prior Performance Affect a Mutual Fund’s Choice of Risk? Theory and Further Empirical Evidence
Chen, H., & Pennacchi, G. (2009) · Journal of Financial and Quantitative Analysis · doi:10.1017/s002210900999010x · Cited by 188 · see citing works
“In addition, if managerial ability displays decreasing returns to scale, Berk and Green (2004) show that fund flows determine the relative sizes of mutual funds such that, in equilibrium, investors expect no future superior returns net of fund fees and expenses.”
BackgroundDoes Herding Behavior Reveal Skill? An Analysis of Mutual Fund Performance
Jiang, H., & Verardo, M. (2018) · The Journal of Finance · doi:10.1111/jofi.12699 · Cited by 188 · see citing works
Presidential Address: Investment Noise and Trends
Stambaugh, R. (2014) · The Journal of Finance · doi:10.1111/jofi.12174 · Cited by 148 · see citing works
Style effects in the cross-section of stock returns
Teo, M., & Woo, S.-J. (2004) · Journal of Financial Economics · doi:10.1016/j.jfineco.2003.10.003 · Cited by 176 · see citing works
“The sensitivity of the Bayesian persistence results to fund inflow resonates with the Berk and Green (2002) argument that fund inflows compete away managerial alpha.”
Incentives and Mutual Fund Performance: Higher Performance or Just Higher Risk Taking?
Massa, M., & Patgiri, R. (2008) · Review of Financial Studies · doi:10.1093/rfs/hhn023 · Cited by 177 · see citing works
“Consistent with the theory of Berk and Green (2004), we find that inflows have a negative impact on risk-adjusted returns.”
Ben‐David, I., Franzoni, F. A., & Moussawi, R. (2017) · Annual Review of Financial Economics · doi:10.1146/annurev-financial-110716-032538 · Cited by 181 · see citing works
An Institutional Theory of Momentum and Reversal
Vayanos, D., & Woolley, P. (2008) · National Bureau of Economic Research · doi:10.3386/w14523 · Cited by 181 · see citing works
Exchange-Traded Funds 101 for Economists
Martin Lettau, A., & Madhavan, A. (2018) · The Journal of Economic Perspectives · doi:10.1257/jep.32.1.135 · Cited by 178 · see citing works
Portfolio concentration and performance of institutional investors worldwide
Choi, N. Y., Fedenia, M. A., Skiba, H., & Sokolyk, T. (2016) · Journal of Financial Economics · doi:10.1016/j.jfineco.2016.09.007 · Cited by 177 · see citing works
- Authors
- Berk, J. B., & Green, R. C.
- Affiliations
- National Bureau of Economic Research (US)
- Carnegie Mellon University (US)
- ORCID
- Berk, Jonathan B.
- Venue
- Journal of Political Economy
- Publisher
- University of Chicago Press
- Published
- 2004-12
- Volume
- 112
- Issue
- 6
- Pages
- 1269-1295
- ISSN
- 0022-3808 (ISSN-L)
- 1537-534X
- OpenAlex
- W3022326679
- Cited by
- 2,083
- References
- 16
- Citations by year
- 2026: 118 · 2025: 123 · 2024: 179 · 2023: 135 · 2022: 128 · 2021: 130 · 2020: 130 · 2019: 105 · 2018: 106 · 2017: 97 · 2016: 83 · 2015: 93 · 2014: 72 · 2013: 92 · 2012: 105
- FWCI
- 54.34
- Type
- journal article
- Language
- en
- Open access
- closed
- Locations
- Journal of Political Economy (publishedVersion)
- RePEc: Research Papers in Economics (submittedVersion)
- Topics
- Social Sciences › Economics, Econometrics and Finance › Finance › Financial Markets and Investment Strategies
- Social Sciences › Business, Management and Accounting › Accounting › Corporate Finance and Governance
- Social Sciences › Business, Management and Accounting › Accounting › Financial Analysis and Corporate Governance
- Keywords
- mutual fund flows, fund performance, active portfolio management, rational expectations, performance persistence, active vs passive investing, financial intermediaries, information aggregation
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