Bayesian Performance Evaluation

This paper proposes a Bayesian method of performance evaluation for investment managers. We begin with a flexible set of prior beliefs that can be elicited without any reference to probability distributions or their parameters. We then combine these prior beliefs with a general multi-factor model and derive an analytical solution for the posterior expectation of alpha', the intercept term from the model. This solution can be computed using only a few extra steps beyond maximum likelihood estimation and does not require a comprehensive or bias-free database. We then apply our methodology to a sample of domestic diversified equity mutual funds and ask what prior beliefs would imply zero investment in active managers?' To justify such a zero-investment strategy, we find that a mean-variance investor would need to believe that less than 1 out of every 100,000 managers has an expected alpha greater than 25 basis points per month. Overall, our analysis suggests that even when the average manager is expected to underperform passive benchmarks, it requires very strong prior beliefs to imply zero investment in managers with the best past performance.

On the performance of mutual fund managers

This study examines the performance of mutual fund managers using a newly constructed database that tracks 2,086 managers of domestic diversified equity mutual funds during their careers from 1992 to 1999. One never observes performance outcomes of managers and funds independently but only in conjunction with each other. This paper recognizes that fact and treats managers, funds, and “manager-fund combinations” as separate entities. I investigate performance from three perspectives. First, I examine performance persistence among managers and find some support for persistence. Second, to study the attribution of performance outcomes between managers and funds, I model abnormal performance as a Cobb-Douglas production function with manager and fund inputs, and develop a Bayesian framework to estimate it. Depending on one\u27s prior beliefs I find that the fraction of abnormal returns contributed by the manager ranges from approximately 10 to 50 percent. The remaining 90 to 10 percent is contributed by the fund. Third, I investigate whether managers can attract fund flows on the basis of their past performance and find scarce evidence that they are able to do so. This study concludes that the fund is at least as important as the manager for performance.* *This dissertation includes a CD that is compound (contains both a paper copy and CD as part of the dissertation). The CD requires the following system application: Adobe Acrobat

Global Liquidity and Asset Prices

Much recent commentary suggests that global liquidity has influenced financial conditions in the major international markets to an important degree, and that excess liquidity in one financial center can influence financial conditions elsewhere. Little formal research has addressed these issues, however. In this paper, we use three indexes of liquidity (money growth) in the Group of Seven industrial countries to explore the international dimension of the relationship between liquidity and asset returns. Evidence suggests that an increase in G-7 liquidity is consistent with a decline in G-7 real interest rates and an increase in G-7 real stock returns. There is also evidence of liquidity spillovers across countries.

Should investors avoid all actively managed mutual funds? A study in Bayesian performance evaluation

This paper analyzes mutual-fund performance from an investor’s perspective. We study the portfolio-choice problem for a mean-variance investor choosing among a risk-free asset, index funds, and actively managed mutual funds. To solve this problem, we employ a Bayesian method of performance evaluation; a key innovation in our approach is the development of a flexible set of prior beliefs about managerial skill. We then apply our methodology to a sample of 1,437 mutual funds. We find that some extremely skeptical prior beliefs nevertheless lead to economically significant allocations to active managers. ACTIVELY MANAGED EQUITY MUTUAL FUNDS have trillions of dollars in assets, collect tens of billions in management fees, and are the subject of enormous attention from investors, the press, and researchers. For years, many experts have been saying that investors would be better off in low-cost passively managed index funds. Notwithstanding the recent growth in index funds, active managers still control the vast majority of mutual-fund assets. Are any of these active managers worth their added expenses? Should investors avoid all actively managed mutual funds? Since Jensen ~1968!, most studies have found that the universe of mutual funds does not outperform its benchmarks after expenses. 1 This evidence indicates that the average active mutual fund should be avoided. On the other hand, recent studies have found that future abnormal returns ~“alphas”! can be forecast using past returns or alphas, 2 past fun