Limits to mutual funds' ability to rely on mean/variance optimization |
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| Institution: | 1. School of Business, The Citadel, 171 Moultrie Street, Charleston, SC 29409-6190, United States;2. U.S. Securities and Exchange Commission, Division of Economic and Risk Analysis, 100 F Street N.E., Washington D.C. 20549, United States;1. Cass Business School and Centre for Economic Policy Research (CEPR), London, UK;2. Institute of Finance, University of Lugano, Via Buffi 13, CH-6900 Lugano, Switzerland;3. Department of Finance, Copenhagen Business School, DK-2000 Frederiksberg, Denmark;1. Nottingham Trent University, Nottingham Business School, Burton Street, NG1 4BU Nottingham, UK;2. University of Macedonia, Department of Economics, 156 Egnatia Street, 54006 Thessaloniki, Greece;3. University of Bologna, Department of Economics, Via Anghera 22, 47900 Rimini, Italy;4. Wilfrid Laurier University, Canada;5. Johns Hopkins University, SAIS Bologna Center, Italy;6. Rimini Centre for Economic Analysis (RCEA), Italy;1. Department of Economics, University of Bologna, Piazza Scaravilli, 2, Bologna 40126, Italy;2. Rimini Centre for Economic Analysis, Rimini, Italy;3. Judge Business School, University of Cambridge, Trumpington Street, Cambridge CB2 1AG, UK;4. Department of Finance, Accounting and Economics, Frederick University, Mariou Agathagelou 18, Limassol, Cyprus;1. University of Technology, Sydney, Finance Discipline Group, UTS Business School, P.O. Box 123, Broadway, NSW 2007, Australia;2. University of New South Wales, School of Banking and Finance, UNSW Business School, Sydney, NSW 2052, Australia |
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| Abstract: | Our evidence suggests that estimation error in the required statistics is an important factor inhibiting investors' ability to rely on mean/variance analysis. We compare the returns reported by mutual funds to the returns obtained from a mean/variance optimized portfolio of fund holdings. The results suggest that funds tend to outperform the optimized portfolio out-of-sample (when means/variances/covariances are unknown), but under-perform in-sample (when the required statistics in the optimization are known). Therefore, a popular assumption in asset pricing models that investors rely on a basic mean/variance analysis with known underlying statistics is likely to be grossly violated in the case of mutual funds. |
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