A Signaling Theory of Mutual Fund Activeness

We propose a theory of self-selection by mutual fund managers into stock "picking" and market "timing." With adverse selection, investors learn more easily about the skill of picking funds than of timing funds, since picking investments are less correlated than timing investments. The equilibrium allocation of talent across strategies is such that high-skill managers always pick, while low-skill managers time with positive probability. We empirically confirm the predictions that picking funds generate more value, are larger, and exhibit higher flow-performance sensitivity than timing funds, and that higher aggregate volatility induces a higher fraction of low-skill managers to time the market.