Investing in equity mutual funds

Authors construct optimal portfolios of equity funds by combining historical returns on funds and passive indexes with prior views about asset pricing and skill. By including both benchmark and nonbenchmark indexes, authors distinguish pricing-model inaccuracy from managerial skill. Modest confidence in a pricing model helps construct portfolios with high Sharpe ratios. Investing in active mutual funds can be optimal even for investors who believe managers cannot outperfofm passive indexes. Optimal portfolios exclude hot-hand funds even for investors who believe momentum is priced. Our large universe of funds offers no close substitutes for the Fama-French and momentum benchmarks.

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