Minimizing Risk in the Ghanaian Banking Sector Essay

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Investing in Mutual Funds when Returns are Predictable

DORON AVRAMOV AND RUSS WERMERS*

First draft: May 26, 2004 This Revision: April 21, 2005

*Doron Avramov is from the University of Maryland, e.mail:davramov@rhsmith.umd.edu, Tel: 301405-0400, and Russ Wermers is from the University of Maryland, e.mail: rwermers@rhsmith.umd.edu, Tel: 301-405-0572. We thank seminar participants at Copenhagen Business School, George Washington University, Inquire-UK and Inquire-Europe Joint Spring Conference, Institute for Advanced Studies (Vienna), Stockholm Institute for Financial Research (SIFR), Tel Aviv University, University of Manitoba, University of Toronto, Washington University at St. Louis, and especially an anonymous referee, for useful
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investor. Since about 90 percent of these funds are actively managed, researchers have devoted extensive efforts to study their performance and have found that, on average, active management underperforms passive benchmarks.1 Recent articles show more promising evidence of active management skills among subgroups of funds. For example, Baks et al (2001) find that mean-variance investors who are skeptical about active management skills can identify mutual funds that generate ex ante positive alphas.

Further evidence on the value of active management during different phases of the business cycle has been provided by Moskowitz (2000), who demonstrates that actively managed funds generate an additional 6% per year during recessions versus expansions. A related body of work has documented the importance of incorporating business-cycle variables, such as the aggregate dividend yield, in making investment decisions among the market index, equity portfolios, and individual stocks.2 Both of these areas of research suggest that we might use business-cycle variables to identify outperforming actively managed equity funds.

This paper studies portfolio strategies that invest in equity mutual funds, incorporating predictability in (i) manager selectivity and benchmark-timing skills, (ii) fund risk-loadings, and (iii) benchmark returns. Ultimately, we provide new evidence on the promise of equity mutual funds by assessing the ex ante investment opportunity

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