Title: Mutual fund performance and the incentive to invest in active management
Description: "It is well known that within U.S.  domestic equity mutual funds, actively managed funds significantly underperform index funds.  However, this comparison ignores the fact that mutual funds targeted at different types of investors charge different fees, and use these fees to provide different bundles of services.  To control for these differences, we compare the performance of actively managed funds and index funds within each of three broad market segments: retail funds sold directly to investors, retail funds sold through brokers, and institutional funds.  We find that underperformance is strongest in the broker-sold segment and weakest in the direct-sold segment.  In fact, we find that within the direct-sold segment, the risk-adjusted, after-fee returns of actively managed funds are statistically indistinguishable from those of index funds, consistent with the equilibrium condition in Grossman and Stiglitz (1980).  To rationalize differences in performance, we test for differences in the flow-performance relation across the three segments.  We find that fund flows respond most strongly to risk-adjusted returns in the direct-sold segment.  We find a wide variety of evidence that direct-sold funds respond to investor preferences for risk-adjusted performance by investing more in active management.  Our findings suggest that the underperformance of the average actively managed fund reflects its weaker incentives to generate alpha rather than an inability to generate alpha.  We argue that our findings also help to explain the continued demand for actively managed funds"--National Bureau of Economic Research web site.