Abstract
Using daily returns, we find that Bayesian alphas that incorporate fund expenses and a long history of factor returns predict future mutual fund Sharpe ratios significantly better than traditional measures. For investors who believe in managerial skill, Bayesian measures choose funds that subsequently outperform funds chosen by standard single- or four-factor alphas. For investors who are skeptical of managerial skill, Bayesian measures choose funds that subsequently outperform funds chosen by expenses. Over our entire sample period, we find that priors consistent with a moderate belief in managerial skill dominate the more extreme skeptical or diffuse prior beliefs. Since a model with diffuse prior beliefs in managerial skill best predicts actual fund cash flows, our results suggest that Bayesian alphas can help investors choose better performing funds.
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