Do actively managed mutual funds exploit stock market mispricing?

Abstract

Constructing a proxy for mispricing with 15 well-known stock market anomalies, we examine whether actively managed mutual funds exploit mispricing. We find that, in the aggregate, mutual funds overweight overvalued stocks and underweight undervalued stocks relative to a passive benchmark, and this tendency is explained by the ill-motivated trades of agency-prone fund managers. In addition, we find that mutual funds with the highest weights in undervalued stocks outperform those with the highest weights in overvalued stocks by an annualized three-factor alpha of 2.12% (t = 2.38), implying that slanting portfolios based on our proxy helps mutual funds improve performance.