ANOTHER PUZZLE - THE GROWTH IN ACTIVELY MANAGED MUTUAL FUNDS

Mutual funds represent one of the fastest growing type of financial in termediary in the American economy. The question remains as to why mut ual funds and in particular actively managed mutual funds have grown s o fast, when their performance on average has been inferior to that of index funds. One possible explanation of why investors buy actively m anaged open end funds lies in the fact that they are bought and sold a t net asset value, and thus management ability may not be priced. If m anagement ability exists and it is not included in the price of open e nd funds, then performance should be predictable. If performance is pr edictable and at least some investors are aware of this, then cash flo ws into and out of funds should be predictable by the very same metric s that predict performance. Finally, if predictors exist and at least some investors act on these predictors in investing in mutual funds, t he return on new cash flows should be better than the average return f or all investors in these funds. This article presents empirical evide nce on all of these issues and shows that investors in actively manage d mutual funds may have been more rational than we have assumed.