Heuristic Fund Allocation Decisions

Abstract

We demonstrate that fund investors employ a heuristic benchmark model to estimate alphas and allocate capital. This can result in observational equivalence to CAPM driven investment decisions. The benchmark estimator trades off bias against precision, accommodating finite sample constraints. The estimator does not require knowledge of the (unknown) true model. Under a diffuse prior on alpha, the benchmark estimator dominates factor model estimates by the MSE criterion in 88% of our sample. We derive a sufficient condition under which the benchmark estimator dominates, even when the true pricing model is known. Fund investors employ a sophisticated approach to capital allocation.

Keywords: heuristics, mutual fund flows, sector funds, sophistication, model uncertainty

JEL Classification: G11