TAILIEUCHUNG - Investing in Equity Mutual Funds

We construct optimal portfolios of equity funds by combining historical returns on funds and passive indexes with prior views about asset pricing and skill. By including both benchmark and nonbenchmark indexes, we distinguish pricing-model inaccuracy from managerial skill. Even modest con¯dence in a pricing model helps construct portfolios with high Sharpe ratios. Investing in active mutual funds can be optimal even for investors who believe active managers cannot outperform passive indexes. Optimal portfolios exclude hot-hand funds even for investors who believe momentum is priced. Our large universe of funds o®ers no close substitutes for the Fama-French and momentum benchmarks | Investing in Equity Mutual Funds by Lubos Pastor and Robert F. Stambaugh August 2001 Abstract We construct optimal portfolios of equity funds by combining historical returns on funds and passive indexes with prior views about asset pricing and skill. By including both benchmark and nonbenchmark indexes we distinguish pricing-model inaccuracy from managerial skill. Even modest confidence in a pricing model helps construct portfolios with high Sharpe ratios. Investing in active mutual funds can be optimal even for investors who believe active managers cannot outperform passive indexes. Optimal portfolios exclude hot-hand funds even for investors who believe momentum is priced. Our large universe of funds offers no close substitutes for the Fama-French and momentum benchmarks. JEL Classifications G11 G12 C11 Keywords mutual funds portfolio selection Graduate School of Business University of Chicago Pastor and the Wharton School University of Pennsylvania and the National Bureau of Economic Research Stambaugh . Research support from the Center for Research in Security Prices and Dimensional Fund Advisors is gratefully acknowledged Pastor . We are grateful to several anonymous referees Eugene Fama Wayne Ferson Anthony Lynch Andrew Metrick Dean Paxson Toby Moskowitz and seminar participants at Emory University the Federal Reserve Bank of New York Northwestern University Ohio State University University of Chicago University of Pennsylvania University of Rochester Vanderbilt University the 2000 NBER Summer Institute the 2000 Portuguese Finance Network Conference and the 2001 AFA Meetings for helpful comments. This paper is based in part on the authors earlier working paper Evaluating and Investing in Equity Mutual Funds. 1. Introduction Selecting a portfolio of mutual funds involves a combination of data and judgment. Relying solely on historical fund returns risks overinvesting in funds that have been lucky especially when funds have short track records. An investor .

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