October 29, 2015
We estimate an option-based value of a fund manager’s conditional market timing skill in bear market states. We combine this value with alpha based estimates of selection skill to give an overall valuation of active management. At the aggregate level, we estimate that the benefit arising from the option value of active fund management in bad times can be large enough to cover its unconditional overall cost. Our analysis suggests that by taking account of the option premium delivered by managers’ bear market timing skills, the longstanding mutual fund underperformance puzzle could be largely rationalized.