Rational Attention Allocation over the Business Cycle
63 Pages Posted: 29 May 2009 Last revised: 15 Aug 2012
Date Written: August 14, 2012
The literature assessing whether mutual fund managers have skill typically regards market timing or stock picking skills as immutable attributes of a manager or fund. Yet, measures of these skills appear to vary over the business cycle. This paper offers a rational explanation, arguing that timing and picking are tasks. A skilled manager can choose how much of each task to attend to. Using tools from the rational inattention literature, we show that in booms, a manger should pick stocks and in recessions, he should pay more attention to his market timing. The model predicts equilibrium outcomes in a world where a fraction of managers have skill and invest alongside unskilled investors. The predictions about funds' covariance with payoff shocks, cross-fund dispersion, and their excess returns are all supported by the data. In turn, these findings offer new evidence to support two broader ideas: that some investment managers have skill and that attention is allocated rationally.
Keywords: information choice, investment management, business cycle
JEL Classification: D8, E32, G11, G12, G14, G23
Suggested Citation: Suggested Citation