Best ideas

This paper provides powerful evidence that mutual fund managers can pick stocks that outperform the market. Many have argued that the inability of mutual fund managers to outperform benchmarks is the most persuasive evidence in favor of capital market efficiency. Berk and Green (2004) argue that this is not necessarily the case, because factors related to the structure of the money management industry will cause even good stock pickers not to outperform. We circumvent this problem by examining the performance of stocks that represent managers' "Best Ideas." We find that the stock that active managers display the most conviction towards ex-ante, outperforms the market, as well as the other stocks in those managers' portfolios, by approximately 39 to 127 basis points per month depending on the benchmark employed. This leads us to two conclusions. First, the U.S. stock market does not appear to be efficiently priced, since even the typical active mutual fund manager is able to identify a stock that outperforms. Second, consistent with the view of Berk and Green, the organization of the money management industry appears to make it optimal for managers to introduce stocks into their portfolio that are not outperformers, even though they are able to pick good stocks.

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