Financial Intermediaries vs. Capital Allocation: The Forgotten Role of Mutual Funds

Recent evidence challenges the allocational efficiency of firms (in allocating capital to more productive sectors). We investigate whether financial intermediaries can help achieve better allocation. We find domestic mutual funds exhibit significant allocational efficiency in their equity investments due to managers’ active choices. Moreover, mutual funds can allocate capital more efficiently than real investments (made by firms) and a list of alternative sources (e.g., fund benchmarks and analyst forecasts). Allocational efficiency also allows funds to deliver superior performance, implying a novel source of managerial skills. Our results suggest that financial intermediation helps the market achieve efficiency in resource allocation.