A Rational Model of Active Portfolio Management
Richard Green, Carnegie-Mellon University
Jonathan Berk, University of California, Berkeley

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. 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 actively managed 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 flow of funds exists in our model: Indeed, this is the market mechanism that ensures that no predictability in performance exists. Choosing parameters to match the flow-performance relationship 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. (Accepted Summer, 2003)

Understanding the relations among performance, fund flows, fund scale, and manager compensation is essential to choosing a good investment manager, to successfully running a profitable investment manager, to retaining successful managers, and to selling investment management services. Thus the topics in this study thus should be of great interest to our members. This study is of particular importance because it provides a simple explanation for why skilled managers do not outperform passive benchmarks.