Rational Cross-Sectional Differences in Market Efficiency : Evidence from Mutual Fund Returns

Markets should be inefficient enough to allow returns to security analysis to adequately compensate the marginal analyst for his efforts. Cross-sectional differences in the costs of analysis therefore imply cross-sectional differences in market efficiency and in before-cost returns to smart investors. I examine abnormal returns of mutual fund investments in two stock types that were costly to analyze: small growth stocks over 1980-2006 and internet stocks over 1999-2000. Small growth stocks held by funds earned average monthly abnormal returns of 0.76%. Internet stocks held by technology funds outperformed other internet stocks by 3% per month