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

Paper: arXiv 2212.02307

Authors: Radu Burlacu, Patrice Fontaine, Sonia Jimenez-Garcès

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.

Complexity vs Empirical Score

• Math Complexity: 6.5/10
• Empirical Rigor: 6.0/10 (capped from 7.5: no out-of-sample test; see penalty flags)
• Quadrant: Holy Grail — high math complexity, high empirical rigor

Why this score: The paper provides a strong theoretical and empirical bridge by grounding mutual fund performance evaluation in the Grossman-Stiglitz asymmetric information framework. By constructing a custom reference portfolio using price and supply data, it effectively resolves a long-standing puzzle regarding the rational demand for active management.

Research Flowchart

  flowchart TD
    A[Research Goal: Evaluate Active Mutual Fund Performance for Uninformed Investors] --> B[Input Data: Prices, Supply & Fund Characteristics]
    B --> C[Methodology: Construct Reference Portfolio via Grossman-Stiglitz Framework]
    C --> D[Compute Fund Alphas vs. Reference Portfolio & Market Index Proxy]
    D --> E[Outcome 1: Near-Zero Alpha +0.23% vs. Reference Portfolio]
    D --> F[Outcome 2: Negative Alpha -1.28% vs. Standard Market Index]
    E & F --> G[Conclusion: Active Management Adds Value for Uninformed Investors]