Mutual fund performance: A market efficiency perspective

The central contribution of our paper is the combination of market efficiency and performance evaluation research by examining mutual fund performance in relation to weak form market efficiency. We combine a time-varying weak form efficiency proxy with a time-varying measure for alpha from an unconditional four-factor model (Carhart, 1997). Doing so, we examine the relationship between market efficiency and alpha, and when and how performance is realized by fund managers, conditional on the relative market efficiency of the market. We confirm that most fund managers are not able to outperform the market. They typically lead to lower performances. Only a limited number of fund managers are able to systematically outperform the market and they typically do so by limiting losses in times of market inefficiency and also by profiting from subsequent learning effects, consistent with the theory of Adaptive Markets Hypothesis (AMH). Conditioning fund performance on market efficiency, we are able to construct a conditional alpha ratio, which provides a new tool that allows investors to better select mutual funds. All in all, market efficiency clearly helps in identifying good fund management, which in turn can help investors make better fund selection decisions. Our results also illustrate the possible reconciliation on two levels. First, this study provides the insight that efficient market theory and behavioral finance can in fact go hand in hand. Second, it aligns finance academics and professionals, as it shows that active fund management is not always completely obsolete, although markets are generally rather weak form efficient.