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Smart money or dumb money? A study on the selection ability of mutual fund investors in China
Abstract
We examine investors’ mutual fund selection ability in China. Using actively managed equity mutual funds between 2005 and 2011, we find that Chinese investors generally have no mutual fund selection ability, a result contrary to the smart money effect in the United States. We show that mutual funds that receive more new money subsequently underperform significantly. The findings are robust to several risk-adjusted performance measures. The unique data of China provide separate accounts of institutional and individual investors’ new money flowing into and out of mutual funds, allowing us to examine the mutual fund selection ability of institutional and individual investors. We document that institutional investors exhibit a smart money effect, that is, they are able to move new money into (out of) future good (poor) performers. In contrast, individual investors exhibit a dumb money effect. Our results provide useful information for regulators to review their rules, especially for the protection of individual investors regarding mutual fund investing in China. In addition, we show that it is useful to distinguish institutional and individual investors in mutual fund research.
... (Bose, 2012) India Mutual Funds Domestic Inst, FII Aggregate Gross mutual fund flows of domestic investors have negative correlation to one-day lagged market returns while foreign institutional investor flows have a positive relation to returns. (Feng, Zhou, & Chan, 2014) China ...
... performance of markets or funds. Their reaction to performance is asymmetrical with stronger positive flow correlation to winning stocks/funds and a weaker negative flow correlation to poorer performing stocks/funds; In contrast, Finnish retail and domestic institutional investors (Grinblatt & Keloharju, 2001) and Indian retail investors (Bose, 2012) are contrarian oriented with flows negatively correlated to contemporaneous and lagged market returns; Except in the UK (Keswani & Stolin, 2008), retail investors in the US (Frazzini & Lamont, 2008;Friesen & Sapp, 2007); Taiwan (Barber, Lee, Liu, & Odean, 2006); India (Chhabra, De, Gondhi, & Pochiraju, 2011) and China (Feng, Zhou, & Chan, 2014) lose money due to trading in stocks exhibiting a dumb money effect. ...
... In contrast, institutional investors show a smart money effect in the studies for the US (Gruber, 1996;Zheng, 1999); UK (Keswani & Stolin, 2008), Taiwan (Barber et al., 2006), India (De, Gondhi & Sarkar, 2012) and China (Feng et al., 2014); The result of these contrasting behaviours of retail and institutional investors means retail investors are losing out to their institutional brethren by excessive trading (De et al., 2012;Frazzini & Lamont, 2008). ...
This paper highlights the “dumb money” effect of Indian retail mutual fund investors who chase funds that subsequently underperform. Retail investors show twice the propensity to chase top past performers, their cash flows are strongly negatively correlated to contemporaneous market returns indicating a contrarian rather than a “buy and hold” strategy. They make up to 1.3% less in terms of raw returns compared to institutional investors and the gap is accentuated for funds with superior risk adjusted returns. Collectively the results reveal retail investors trade actively with poor timing and fund selection skills despite having access to professional fund management.
... When the information in the transaction is valuable, the feedback trading strategy will return the price to the fundamentals [12][13][14]. In addition, rational institutional investors will also show the smart money effect; they have the ability to transfer new funds to performers who perform well in the future [15]. Based on the feedback trading strategy and smart money theory, against the special background of the U.S.-China trade war and the characteristics of institutional investors, we consider the impact of market sentiment on future investment willingness and market risk. ...
... The smart money theory holds that institutional investors make judgments and decisions based on sufficient information about the market or the stocks they have. Rational institutional investors will also show the smart money effect; they have the ability to transfer new funds to performers who perform well in the future [15]. Generally speaking, the smart money theory can dilute the irrational behavior of some ordinary investors. ...
In the current situation of U.S.-China trade turbulence, this study focuses on quarterly panel data from May 2016 to September 2019 in order to verify the effectiveness of feedback trading strategy and smart money theory in stabilizing U.S.-China securities markets and to understand the role of institutional investors’ behavior, to come up with suggestions for improving and perfecting the market mechanism in stabilizing the U.S.-China securities markets. In this study, we adopt the generalized method of moments (GMM) to perform dynamic panel data analysis and discuss the changes in professional institutional investors’ behavior and equity market sentiment in the U.S. and China during the trade turbulence, and then analyze whether that behavior will suppress local stock market sentiment. Through empirical research, we found that institutional investors on both sides of the trade turbulence have a different impact on the stability of the local securities market. The behavior of institutional investors in the United States has played a role in stabilizing equity market sentiment in accordance with feedback trading strategy and smart money theory. However, the behavior of institutional investors in China is the opposite.
... Does the delegation relation alter the impact of sentiment on investing performance compared to direct investments? Empirical evidence on smart money or dumb money effect outside the U.S. is rare (Feng, Zhou, and Chan 2014). Does chasing hot funds pan out for investors in other countries? ...
... While the dumb money effect has been documented in the literature (Frazzini and Lamont 2008;Feng, Zhou, and Chan 2014;Akbas et al. 2015), this study provides some evidence how it may occur by identifying a crucial link between fund-specific investor sentiment and fund performance. The findings in Section 3 suggest that in response to investor sentiment fund managers tactically adjust investments in a manner consistent with rational behaviours in delegated portfolio management as argued in theoretical propositions (Wang et al. 2017). ...
This study provides empirical rationale and guidance for incorporating investor sentiment into mutual fund enterprise information systems. It investigates the effect of fund-specific investor sentiment on fund risk taking and performance. Working on a sample of equity funds in China, our panel regressions reveal that fund risk-taking is negatively related to lagged fund-specific investor sentiment. Investor sentiment is negatively linked to subsequent fund performance, which conforms with the dumb money effect. Encouragingly, there is evidence that mutual fund managers in China possess investing expertise. Fund-specific investor sentiment shows asymmetric impacts. The dumb money effect is primarily driven by positive sentiment.
... Existing research based on earlier dataset before the enforcement of the revised LPRCSIF reports that Chinese mutual funds lack performance persistence and investors tend to make less optimal decisions in fund investment. Therefore, the smart money effect which is revealed in the US market is not observed in China (Feng et al., 2014;Gruber, 1996;Jun et al., 2014;Zheng, 1999). This can be ascribed to the unfamiliarity of investors with the funds that they are going to trade. ...
... We see from the top region that in the pre-reform period, there is a strong positive performance-flow relationship (High i, Extant studies reveal that good performance of Chinese mutual fund is less likely to persist (Feng et al., 2014;Jun et al., 2014). In a rational context, Chinese investors are not expected to purchase past star performers. ...
Extant literature shows the positive impact of institutional development on investor rationality and market efficiency. The authors extend this evidence by investigating the performance-flow relationship in the Chinese mutual fund market before and after the enforcement of the revised Law of the People’s Republic of China on Securities Investment Fund. Empirical evidence reveals that Chinese investors irrationally chase past star performers before institutional reform, but gradually become rational and less obsessed with star-chasing behaviors after reform. Moving one percentile upward in the relative performance among the star funds is associated with money inflows by 0.532% after reform, much lower than 1.433% before reform. The findings confirm the positive influence of institutional development on investor rationality and market efficiency. The successful experience can be borrowed by other emerging markets with less developed institutions.
... The Chinese investors do not show smart fund selection skills [14]. This blind selection could be attributed to low-performance persistence, as performance volatility makes selection difficult [15]. ...
In many financial markets across the globe, full historical position disclosure is not required of mutual funds, or it is subject to prolonged delays, often due to regulatory restrictions. This makes measuring fund manager performance based upon the stock-picking and market-timing skills from past literatures impossible. This study introduces a new methodology utilizing sector weight analysis to estimate the stock-picking and market timing skills of 198 Chinese equity mutual fund managers. Within-sample predictions confirm that the new measures are robust and reliably identify fund managers who outperform their peers, suggesting that this method may be useful in other institutional settings where the full historical position of funds is unavailable. Fund managers with lower stock picking or market timing skills are more likely to improve their skills in the following period, which suggests that manager skills develop and change over time. Finally, our analysis reveals that fund managers with higher stock picking skills are significantly less likely to be replaced, thereby enjoying greater job security.
... Instead, they identify a "dumb money" effect among SRI institutional funds. In the domestic market, Feng et al. (2014) find that Chinese investors are unable to select superior funds. The funds that received more cash flows subsequently performed worse than other funds, and further tests suggest that institutional investors have the smart money effect, while individuals only show the stupid money effect. ...
Impact Statement
This study examines the investor behavior of mutual funds in China. Our results show little evidence about the redemption puzzle. We further refute the disposition effect, that is, investors do not tend to redeem funds with superior past performance. Additionally, market conditions are crucial for investment decisions. In bull markets, investors are prone to taking risks while being conservative and prudent during bad times. Considering investor heterogeneity, we find that institutional investors value the funds’ past performance metrics, assigning greater weight to historical performance. Both institutional investors and individual investors show stronger sensitivity to complicated performance indicators in bad times than good times. Furthermore, we find that investors in China chase for the star funds. We also perform tests on the existence of the smart money effect, and the results show that investors can screen good funds from bad ones. Overall, this study offers valuable insights into the decision-making processes of Chinese mutual fund investors, providing a more nuanced understanding of their behavior compared to established financial theories.
... Another form of resource allocation of fund families is the assignment and coordination of fund managers, [18], hypothesize that manager placement strategies are related to market efficiency. Their analysis of US funds in 1991-2010 reveals that to turn around the performance of less efficient funds, fund families are likely to assign skilled managers to them. ...
This study examines fund family performance, in terms of selectivity and market timing skills of fund family managers, in Saudi Arabia, Malaysia, Indonesia, and Pakistan from 2007–2021. Selectivity skills are measured using excess returns, Sharpe ratio, Treynor ratio, Jensen’s alpha, and Carhart’s four-factor model, whereas market timing ability is measured using the Treynor-Mazuy and Henriksson-Merton models. The analysis is carried out on three levels of sample: by entire sample, by country, and by Islamic vs conventional families. The findings evince the good selectivity but poor timing skills of family managers. A novel contribution of this study is that family managers of Islamic and conventional families have different selectivity and timing skills, which can be attributed to the different goals of each type of family.
... Institutional investors are more sophisticated than individual ones since they have better information and more resources to make their investment decisions (Keswani & Stolin, 2008). In this way, they show superior selection skills (Feng, Zhou, & Chan, 2014) and make a more exhausting monitoring of mutual fund managers (James & Karceski, 2006). Thanks to the moderation of agency problems from greater monitoring, funds with institutional share class outperform other funds without this type of share class (Evans & Fahlenbrach, 2012). ...
In this research, I study the exposure of Socially Responsible mutual funds (SR) to black industries (i.e., carbon-intensive sectors: fossil fuel, metal and utilities) and its effect on the financial performance. To this purpose, I analyze the industry portfolio allocation of a sample of 136 actively-managed US SR mutual funds, investing in domestic and global equity, in the period January 2012–December 2018. I observe that the average weight of black industries in these portfolios is 9.51% falling over time (13.45% in 2012 versus 7.40% in 2018). Another finding is that a greater exposure to fossil fuel and metal industries negatively impacts the portfolios' financial performance. In addition, SR funds managed by firms located in Republican-leaning states and in states with greater CO2 emissions per capita, are more exposed to carbon-intensive industries, suggesting that SR funds' managers could be influenced by local factors when making their investment decisions. Finally, I observe that SR funds marketed under “low-carbon” labels live up to their name and are less exposed to fossil fuel and metal industries than other types of SR funds.
... Furthermore, the researchers found that individual investors lack investment knowledge and skills. According to Feng, Zhou and Chan (2014), individual investors have no ability to select mutual funds, suggesting that financial illiteracy is widespread among investors in China. Indeed, individual investors' reliance on heuristics and biases and the poor investment decisions they make spring partly from lack of knowledge and limited information processing skills (Barber & Odean, 2013), which can be mitigated by higher financial literacy. ...
Research aim: This study seeks to examine the knowledge and attitudinal factors that influence financial statement usage among Malaysian individual investors.
Design/ Methodology/Approach: A survey was conducted on a sample of 399 Malaysian individual investors using self-administered questionnaires.
Research finding: The findings reveal that financial statement usage is positively associated with subjective norm, financial statement knowledge, attitude towards financial statement usage, and perceived behavioural control. However, it is negatively associated with trading frequency attitude.
Theoretical contribution/Originality: This study seeks to contribute to the very limited research on the factors that influence individual investors’ financial statement usage. Additionally, it enriches the literature on financial statement usage among individual investors in Malaysia by showing the extent to which the three main financial statements are utilised by them. Furthermore, this research extends financial literacy research on stock investing to the realm of financial statement usage by highlighting the influence of financial statement knowledge on this behaviour. Thus, the study seeks to bridge the gap between financial reporting and financial literacy.
Practitioner/Policy implication: The findings provide useful insights for the providers of investor education programmes in developing more holistic programmes.
Research limitation/Implication: Non-random sampling was employed in this study, albeit such an approach is consistent with the literature. Also, respondents comprised individual investors who are proficient in English because the researchers seek to complement Malaysian studies on the readability of English language financial statement narratives.
Keywords: Financial Reporting, Investment Decision-making, Financial Knowledge
Type of manuscript: Research paper
JEL Classification: M41, G41, D80
... 4. With respect to the fund management industry, specifically, AMAC and the China Securities Regulatory Commission (CSRC)-China's analogue to the SEC-announced in July andAugust 2019 an end to ownership limits for foreign investors in financial firms, plans for the provision of licenses allowing foreign asset managers to participate in the nation's retail funds market, and measures to make it easier for foreign firms to compete with local players. 5.Feng, Zhou, and Chan (2014) find that institutional investors in China are, indeed, capable of identifying skilled mutual funds ex ante, while retail investors systematically invest in the wrong mutual funds-what they refer to as a "dumb money" effect.6. Investment Company Institute, Trends in Mutual Fund Investing, December 2019. ...
... If the fund managers possess stock-picking skills, they will yield a higher risk-adjusted return relative to a benchmark. Market timing ability, also known as macro-forecasting, is the forecasting skill of the portfolio managers to predict the future stock market movements byrebalancing the total risk composition of their portfolios.Different researchers (Jensen, 1968;Elton et al., 1996;Zheng, 1999;Feng et al., 2014) have investigated the portfolio stock selection skill of the fund managers on the risk-adjusted basis. Several studies (Treynor and Mazuy, 1966;Henriksson and Merton, 1981;Henriksson 1984; Chang and Lewellen 1984;Grinblatt and Titman, 1989; Lee and Rahman, 1990;Ferson and Schadt, 1996;Jiang, 2003;Jiang et al., 2007;Cuthbertson et al.,2012;Angelidis, 2013;Bodson et al., 2013;and Ferson and Mo, 2016;Yi and He, 2016)have explored the market timing ability of the fund managers.The majority of thesestudies report little evidence of timing ability among fund managers. ...
We empirically examine fund managers' stock selection and market timing ability using various risk-adjusted measures such as CAPM and multifactor models of Fama-French (1993) and Carhart (1997) to gauge mutual fund performance in India. The sample consists of 183 actively managed equity-oriented funds and covers the period from April 2000 to March 2018. The study, on the whole, documents some evidence of positive and significant stock selection ability but fails to yield any notable evidence of market timing ability of fund managers. Our results are robust according to various risk-adjusted performance evaluation techniques, sub-period analysis, excluding the crisis period and at the individual fund level. The findings of our study are in line with the previous studies that report limited selectivity skill and market timing ability among fund managers. The main implication of the study is that active portfolio management may not be very rewarding in comparison to a passive investment strategy.
... Bena et al. (2017) argued that greater foreign institutional ownership fosters long-term investment in tangible, intangible, as well as human capital and leads to significant increases in innovation output. Feng, Zhou, and Chan (2014) documented that institutional investors exhibit a smart money effect that can move new money into (out of) future good (poor) performers. Ferreira, Massa, and Matos (2009) found that foreign institutional investors, who built bridges between firms and reduce transaction costs as well as information asymmetry between bidder and target, act as the facilitators for corporate control in the international markets. ...
Contemporary Management Research: We investigate whether firms changing their names or industry categories once and more than once would affect institutional shareholdings. By utilizing 5,733 observations of the Taiwan Stock Exchange listed firms, we apply multiple regression models firstly and Petersen regression models for further investigation to enhance the robustness of the empirical results. We then disclose several important findings as follows. First, institutional investors might not prefer holding the shares of the firms changing their names more than once. We infer that the performances of the firms changing names more than once might be doubtful. Second, institutional investors might decrease the shareholdings of the firms with industry categories changed. We claim that institutional investors might suspect these firms probably existing corporate governance issues. Besides, we argue that, to our best understanding, this study might fill the gap in the existing literature due to that the issues, firms changing their names or industry categories once or more than once, seem rarely explored in the relevant studies.
... Russian mutual funds demonstrate the "smart money effect" described by gruber (1996), Zheng (1999), sapp and Tiwari (2004), Chan et al. (2014). This effect assumes that the excess return of funds depends on the current year net flow, i.e. while purchasing shares investors are able to select funds with higher yield. ...
Ксения Акшенцева - младший научный сотрудник Института прикладных экономических исследований Российской академии народного хозяйства и государственной службы при Президенте РФ. Электронная почта ksakshentceva@gmail.com Александр Абрамов - кандидат экономических наук, ведущий научный сотрудник Института прикладных экономических исследований Российской академии народного хозяйства и государственной службы при Президенте РФ, профессор кафедры фондового рынка и рынка инвестиций, Национальный исследовательский университет «Высшая школа экономики». Электронная почта: ae_abramov@mail.ru Despite 19 years of the existence of mutual funds in Russia, their performance and effectiveness remain not deeply investigated subjects. The deficit of academic research has a negative influence on the investors’ and regulator’s attitude towards the collective investment market in Russia. In contrast to many other countries oriented on the development of internal stock market, collective investment in Russia does not yet play an active role in the mobilization of internal private savings.This article intends to partially make up for the lack of knowledge about the economy of mutual funds in Russia. It presents the analysis of three measures of mutual fund performance in Russia: the share return, net flow and management company fee. The analysis is based on a unique dataset which contains information about characteristics of 755 mutual funds and covers a 13 year period of the existence of the collective investment sector in Russia. The mutual fund return is able to outperform inflation, return on government bonds and return on the 50/50 strategy. During the periods 2000-2013 and 2008-2013 the abnormal return, net flow and management company fee have followed the same regularity as their foreign counterparts. Thus, mutual funds are one of the most important players in the Russian financial market. We also showed that for the successful development of collective investment in Russia it is necessary to increase the scale of operations, cost management effectiveness and transparency
... Furthermore, the researchers found that individual investors lack investment knowledge and skills. According to Feng, Zhou and Chan (2014), individual investors have no ability to select mutual funds, suggesting that financial illiteracy is widespread among investors in China. Indeed, individual investors' reliance on heuristics and biases and the poor investment decisions they make spring partly from lack of knowledge and limited information processing skills (Barber & Odean, 2013), which can be mitigated by higher financial literacy. ...
Financial statement literacy is vital in helping individuals make good long-term stock investment decisions and is especially relevant in China where individual investors account for 85 per cent of stock market activity. To delve more into this issue, we examine relevant literature on individual investor behaviour, financial literacy and investment analysis respectively. We note an overall lack of financial literacy studies in China. Furthermore, financial statement literacy has received limited attention in all three streams of literature. This is possibly due to the lack of a systematic model for measuring financial statement literacy. Indeed, current studies tend to rely on secondary data and financial statement literacy is measured in a limited manner. We therefore propose a model in which financial statement literacy is evaluated through three dimensions, namely knowledge, attitudes and behaviour. The model can be extended to examine the influence of financial statement literacy on stock investment decision-making.
... Уровни значимости: * 10%, ** 5%, *** 1%. Chan et al., 2014]. Данный эффект предполагает, что избыточная доходность взаимных фондов зависит от их баланса продаж в текущем периоде, то есть при приобретении паев пайщики умеют отличать фонды с более высокой доходностью. ...
... Their findings also suggest that Chinese financial analysts' reputation is not critical in attracting institutional investors. Feng, Zhou, and Chan (2014) study the selection ability of mutual funds investors in China using a unique dataset covering institutional and individual investors' transactions separately into and out of mutual funds. Using open-end equity mutual funds from the sample period between 2005 and 2011, they show that institutional investors perform better than individual investors in picking up profitable mutual funds due to better resources, motivation and superior skill sets which they have relative to individual investors. ...
This paper reviews the literature on investor reaction and sentiment with respect to public information arrival in emerging markets and discusses the implications of the findings for the validity of theoretical models emphasizing public information arrival as the main mover of asset prices. We cover three types of public information news: monetary policy announcements, the International Monetary Fund (IMF) related news and other public and political news. In addition, we review the literature on sentiment and institutional trading in emerging markets. We summarize general findings and suggest some directions for further research.
Institutional investors' site visits may reduce investors' demand for information, resulting in managers' reluctance to disclose earnings forecasts and exacerbating information asymmetry in the capital market. However, institutional investors may also monitor management through site visits, which increases voluntary management earnings forecasts disclosure and thus reduces information asymmetry. Using a sample of Chinese listed firms from 2012 to 2018, we find that firm management is more likely to voluntarily disclose earnings forecasts after the institutional investors' site visits. Specifically, increasing from the 25th to the 75th percentile of institutional site visits is associated with an increase in the odds of voluntary management earnings forecasts by 24%. We use instrumental variables and Heckman two‐step method to address the endogeneity problems and report similar findings. Additional tests show that the governance effect is amplified among firms with severe type I and type II agency problems or firms with no need for refinancing and alleviating stock price synchronicity. Furthermore, we find that voluntary earnings forecasts are more accurate and more precise after site visits, which means institutional investors' site visits in fact improve the quality of management earnings forecasts. Our findings complement the institutional investors' governance effects on earnings forecasts from the perspective of information acquisition.
In this paper we provide a comprehensive analysis of the performance of US SRI mutual funds as well as its relation to the flow of new money that those funds experience in the context of investors sophistication. In particular, we compare the performance of SRI funds with their conventional peers, matched by both managers and characteristics criteria, using several performance measures. We investigate the role of investors sophistication and its influence on the flow-performance and performance-flow relations within the retail and institutional SRI fund shareclasses. For the analysis of the flow-performance relation we use portfolio approach along with monotonic relation test, while the shape of the flow-performance relation is studied using piecewise linear panel regressions. For the performance-flow relation, the flow and unexpected flow portfolios are formed and their risk-adjusted performance is evaluated. We find that SRI mutual fund sector earns positive abnormal returns before expenses and retail SRI funds outperform their institutional peers both, before and after fees. No differences in performance when we consider SRI and conventional funds run by the same management companies. Moreover, we find a positive flow-performance relation which is convex for retail SRI funds but no convexity is found for the institutional ones. We cannot confirm the smart money effect for retail SRI funds, instead we find a dumb money effect for SRI institutional funds. Our paper provides new insights into the role of the investors sophistication for those relations in the presence of sustainability preferences.
The purpose of this paper is to determine whether affective and non-volitional factors such as desire, positive anticipated emotions, anticipated regret and habits influence mutual fund investor intentions and behaviors.
Design/methodology/approach (100 words)
Using the Model of Goal-directed behavior the impact of including affective factors and habits to a cognitive model was compared against cognitive-only factors. Data was collected through a survey of 321 mutual fund investors across India and analyzed using the Partial Least Squares method.
Findings (100 words)
Results show that goal-based desire was a significant driver of investing intentions while habits drive investing behaviors more than intentions. Anticipated regret strongly influenced desires. The combined hybrid affective-cognitive model demonstrated a 27% and 28% improvement over the cognitive-only model.
Research limitations/implications
Instead of capturing the actual end behavior in a follow up survey this study has used current investments in mutual funds as a proxy for future investing behaviors. Data on end behaviors therefore have to be interpreted with this in mind. Future research directions could include considering the effects of other affective factors like mood, impact of language\religion\culture.
Practical implications
Fund houses and investors need to be aware of emotive drivers and habits that affect investing and act accordingly.
Social Implications
Awareness programs on how emotive issues and habits can hinder as well as enhance investment performance in markets would benefit retail investors.
Originality/value (limit 100 words)
The study is unique in studying affective and non-volitional factors affecting investing behaviors in mutual funds. It uses a theoretical framework from behavioral psychology that has not been applied to financial behaviors before. It is one of the few to analyze both intentions (ex-ante) and end behaviors (post facto) of investors.
Using monthly fund-level portfolio holdings data on Indian equity mutual funds, we explore the predictable patterns in the trading biases of fund managers induced by changing attention allocation patterns. In an emerging market setting, we investigate the tendency of fund managers to sell winners and increase their exposure to losing stocks. Their biases are examined during two states of economic cycles. We adjust for random choice probability while selecting funds for reasons unrelated to the disposition effect. Our research contributes to the relatively nascent psychology-based asset pricing literature by examining fund managers’ psychology concerning financial decision-making.
Flow analysis is a relatively recent methodology, but it is fundamental in understanding of the effect of two processes of dumb money and smart money. Fund flows are dumb money when reallocating across different mutual funds, retail investors reduce their wealth in the long run. Therefore, mutual fund investors are dumb in the sense that their reallocations reduce their wealth on average. The smart-money hypothesis, attributes the positive relation between fund flow and future fund performance to investors’ ability to identify skilled fund managers. The ability of investment funds to generate performance is better identified through the analysis of investment flows, thus, this chapter describes the methodologies suitable for dealing with this task.
While the fund performance management literature has clearly documented that the fund size, fund family size, and net cash flow are important antecedents of equity fund performance, prior empirical studies have revealed mixed results that have not been adequately explained. Through the lens of the contingency perspective, we developed a conceptual model that examines how the expense ratio and management compensation as contextual factors interact with the fund size, fund family size, and net cash flow to affect equity fund performance. The empirical analyses were based on panel data including 690 equity funds in China over a 7-year period from 2009–2015. The results show that the expense ratio and management compensation moderate the effects of the fund family size and net cash flow on fund performance, and management compensation also moderates the relationship between the fund size and fund performance.
We investigate the smart money effect in the German mutual fund market from 2001 to 2016. Results show a positive relation between fund flows and subsequent performance for mutual funds with a European or international diversified investment focus. Funds that invest domestically, however, show no signs of a smart money effect. Moreover, evidence suggests that flows to funds managed by bank-affiliated investment companies are smart. We argue that less sophisticated investors rather invest domestically and that financial advice improves retail investors’ mutual fund investment decisions.
Using a large proprietary database of intraday high‐frequency trading, we investigate the trading strategies of institutional investors in dealing with the negative environmental event disclosure of listed companies and their impact on markets, aiming to reveal the mechanism of the lack of “green efficiency” in China's capital market from the perspective of institutional investors. The results show that institutional investors react to negative environmental events prior to the announcements, indicating premature information leakage in the market; in addition, their trading behaviors mitigate the immediate effect of negative environmental event announcements on stock price. After the event is disclosed, institutional investors engage in short‐term selling and long‐term buy and hold. This trading strategy undermines the irrational selling of individual investors in the event of disclosure, short‐term decline in stock price, and long‐term reversal of market overreaction. In a China context, institutional investors generally take environmental information into consideration. However, they fail to recognize the long‐term value effect of negative environmental events and instead cater to trading strategies towards market volatility.
In this paper, I study investors' selection skills for a broad (576 funds) and updated (January 2004 to May 2018) sample of socially responsible (SR) mutual funds in the US market. In general terms, I obtain a positive relationship between fund flows and subsequent financial performance. This positive relationship is conducted by the bad financial performance of funds suffering net outflows, and it is stronger for non-institutional funds and for funds with a low minimum investment. In addition, I find in general terms that fund flows in US SR funds are persistent, and they are positively related to lagged returns. All these results together seem to indicate that this positive relationship is not driven by investors’ selection skills. Moreover, I observe that religious fund investors are minimally influenced by lagged returns and show the worst selection skills in the US SR fund market. Furthermore, environmental fund investors present the strongest positive relationship between flows and subsequent financial performance, and the flows for these funds are not persistent. When analysing other SR fund markets, I observe in general terms a lack of relationship between fund flows and subsequent financial performance.
Estimating the fund investors’ demand plays an important role in the mutual fund management. In this line, mutual fund demand can be measured as the total net cash flows experienced by the fund during a period. Due to a lack of the data for inflows and outflows in some countries and databases, many authors estimate the net cash flows using fund size and return information. This rough measure, although being a good approximation, implicitly assumes an error in its calculation. For a sample of 2985 US open-end funds, we find evidence that estimating this implied fund flows, the error generated is higher for smaller funds, funds with higher returns, and for those experiencing higher levels of inflows or outflows. This lack of precision leads to a distortion in the estimation of the effect of some determinants on the mutual fund demand, especially when longer periods are considered when constructing the net cash flows.
Resumo: O objetivo deste artigo é o de analisar a capacidade dos investidores em fundos de investimento para selecionar aqueles que apresentam rentabilidade mais elevada. Essa capacidade é denominada na literatura por efeito de smart money. A amostra utilizada diz respeito aos fundos sediados em Portugal, no período de 2003-2011. Os resultados indicam que, em geral, os investidores tiveram boa capacidade de seleção de fundos. Quando o mercado está em fase de subida (descida) de preços, os investidores têm a perícia de selecionar os fundos onde investir (desinvestir), mas não os fundos a liquidar (comprar). A intensidade do smart money parece ainda depender da categoria e da dimensão dos fundos transacionados.
This paper demonstrates that investor sentiment explains the recent puzzle of the negative relation between fees and before-fee performance of equity mutual funds. Using a composite proxy for investor sentiment, the puzzle can be explained stronger by investor sentiment, compared to the strategic fee-setting explanation discussed in the literature. More-sentiment driven investors would like to select more skilled fund managers, leading to a better future performance in short run. Additionally, when sentiment is high (low), it results in lower (higher) fees. Our results highlight the use of investor sentiment approach in determining mutual fund fees and performance.
Using a 2004 Chinese securities regulation that requires equity offering proposals to obtain the separate approval of voting minority shareholders, we examine whether giving minority shareholders increased control over corporate decisions helps to reduce value-decreasing corporate decisions for firms domiciled in weak investor protection countries. We find that the regulation deters management from submitting value-decreasing equity offering proposals in firms with higher mutual fund ownership. There is also weak evidence that minority shareholders are more likely to veto value-decreasing equity offering proposals in firms with higher mutual fund ownership in the post-regulation period. Overall, our evidence suggests that in weak investor protection countries, the effect of granting minority shareholders increased control over corporate decisions on the quality of corporate decisions depends on the composition of minority shareholders.
JEL Classifications: G32; G34; G38
I study the dynamics of investor cash flows in socially responsible mutual funds. Consistent with anecdotal evidence of loyalty, the monthly volatility of investor cash flows is lower in socially responsible funds than in conventional funds. I find strong evidence that cash flows into socially responsible funds are more sensitive to lagged positive returns than cash flows into conventional funds, and weaker evidence that cash outflows from socially responsible funds are less sensitive to lagged negative returns. These results indicate that investors derive utility from the socially responsible attribute, especially when returns are positive.
We estimate parameters of standard stock selection and market timing models using daily mutual fund returns and quarterly
measurement periods. We then rank funds quarterly by abnormal return and measure the performance of each decile the following
quarter. The average abnormal return of the top decile in the post-ranking quarter is 39 basis points. The post-ranking abnormal
return disappears when funds are evaluated over longer periods. These results suggest that superior performance is a short-lived
phenomenon that is observable only when funds are evaluated several times a year.
The authors examine predictability for stock mutual funds using risk-adjusted returns. They find that past performance is predictive of future risk-adjusted performance. Applying modern portfolio theory techniques to past data improves selection and allows the authors to construct a portfolio of funds that significantly outperforms a rule based on past rank alone. In addition, they can form a combination of actively managed portfolios with the same risk as a portfolio of index funds but with higher mean return. The portfolios selected have small but statistically significant positive risk-adjusted returns during a period where mutual funds in general had negative risk-adjusted returns. Copyright 1996 by University of Chicago Press.
This article classifies Chinese mutual funds based on their past investment behavior, using factor and cluster analyses. The empirical results show that the majority of Chinese mutual funds are quasi-indexers (58.58%) which follow a buy-and-hold investment strategy; next are transient mutual funds (31.27%) and dedicated mutual funds (3.38). The results also show that mutual funds generally hold shares of large firms that offer low market risk, low liquidity, and good operating and stock performance. The preferences of quasi-index funds dominate the results. Transient mutual funds focus on good operating performance and growth opportunities. Dedicated funds invest heavily in small, highly liquid listed firms. All types of mutual funds in China prefer to hold state-controlled listed firms rather than privately controlled ones.
This study tries to investigate the performance of specific stylized mutual funds focusing on the matched professional abilities of fund managers, based upon their relative educational backgrounds. Using a 2001-2011 dataset on 1,164 fund managers investing in the Taiwan Stock Exchange comprising mainly of high-tech stocks, our findings suggest that mutual fund managers with joint science and engineering (SE) and business management (BM) backgrounds perform significantly better than fund managers only with business management (BM) background when managing high-tech funds. These results also provide support for the notion that the proliferation of joint degree programs across the associated fields lends credence to the belief that synergies exist between the backgrounds in the stylized mutual funds with professional’s education background of fund manager matching with stock targets.
This paper investigates whether profit-seeking and values-driven investor decisions have an impact on the timing ability of socially responsible mutual fund managers. Surprisingly, we find evidence of successful market timing skill for positively screened mutual fund managers who fulfil the objectives of profit-seeking investors, demonstrating the importance of controlling for the clientele effect. This result may indicate a successful, forward-looking management style in this type of fund. Furthermore, we present certain evidence of the “smart money” phenomenon among profit-seeking investors who pursue the persistent component of returns and thus cause a downward bias in market timing skill.
Directly investing households exhibit more domestically concentrated portfolios than institutional investors. We aim to identify the factors that asymmetrically affect the foreign equity portfolios held by households and institutional investors in four European investing countries – France, Italy, Spain, and Sweden. We find that transparency and being listed on a common exchange platform such as Euronext have larger effects on households’ portfolio decisions than on those of institutional investors. Policies encouraging transparency and common, standardized trading rules can therefore be particularly effective in helping households to better internationally diversify their portfolios.
Using a detailed stockholding for a comprehensive sample of Chinese open-end equity mutual funds from 2004 to the first half of 2010, we investigated the effect of economy of scale and liquidity on the relationship between fund size and performance. We find that an inverted U-shape relationship exists between fund size and performance as measured by various performance benchmarks. Both economy of scale and liquidity play important roles in Chinese mutual funds. Furthermore, their combined effect explains the inverted U-shape relationship of size and performance reasonably well.
Mutual fund investor behavior changes across the business cycle. In economic expansions, investors strongly display the documented behaviors of chasing returns and searching for managerial skill. Expansion investors earn higher returns and alphas by pursuing this strategy, but this result is partially explained by the momentum effect. In contrast, recession investors do not chase returns and exhibit a weaker tendency to seek alpha. Even before controlling for momentum, no smart money effect exists in recessions. Instead of chasing performance, recession investors make investment decisions to change their exposure to aggregate risk factors. Investors tend to avoid funds with exposure to the market and book-to-market factors during recessions, while they show the opposite pattern in expansions.
Mutual fund returns strongly persist over multi-year periods - that is the central finding of this paper. Further, consumer and fund manager behavior both play a large role in explaining these long-term continuation patterns - consumers invest heavily in last-year's winning funds, and managers of these winners invest these inflows in momentum stocks to continue to outperform other funds for at least two years following the ranking year. By contrast, managers of losing funds appear reluctant to sell their losing stocks to finance the purchase of new momentum stocks, perhaps due to a disposition effect. Thus, momentum continues to separate winning from losing managers for a much longer period than indicated by prior studies. Even more surprising is that persistence in winning fund returns is not entirely explained by momentum - we find strong evidence that flow-related buying, especially among growth-oriented funds, pushes up stock prices. Specifically, stocks that winning funds purchase in response to persistent flows have returns that beat their size, book-to-market, and momentum benchmarks by two to three percent per year over a four-year period. Cross-sectional regressions indicate that these abnormal returns are strongly related to fund inflows, but not to the past performance of the funds - thus, casting some doubt on prior findings of persistent manager talent in picking stocks. Finally, at the style-adjusted net returns level, we find no persistence, consistent with the results of prior studies. On balance, we confirm that money is smart in chasing winning managers, but that a "copycat" strategy of mimicking winning fund stock trades to take advantage of flow-related returns appears to be the smartest strategy.
In this paper I derive a risk-adjusted measure of portfolio performance (now known as Jensen's Alpha) that estimates how much a manager's forecasting ability contributes to the fund's returns. The measure is based on the theory of the pricing of capital assets by Sharpe (1964), Lintner (1965a) and Treynor (Undated). I apply the measure to estimate the predictive ability of 115 mutual fund managers in the period 1945-1964 - that is their ability to earn returns which are higher than those we would expect given the level of risk of each of the portfolios. The foundations of the model and the properties of the performance measure suggested here are discussed in Section II. The evidence on mutual fund performance indicates not only that these 115 mutual funds were on average not able to predict security prices well enough to outperform a buy-the-market-and-hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance. It is also important to note that these conclusions hold even when we measure the fund returns gross of management expenses (that is assume their bookkeeping, research, and other expenses except brokerage commissions were obtained free). Thus on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses.
This paper provides evidence on the performance of mutual funds in a prominent emerging market; Poland. Studying an emerging market provides an excellent opportunity to test whether the consensus on the inability of mutual funds in developed and highly efficient markets to beat the market, also holds in less efficient markets. While the weaknesses of legal institutions and underdeveloped capital markets in emerging countries could negatively contribute to performance, a certain level of market inefficiency might also enable fund managers to successfully apply security selection and therefore beat the market. This paper presents an overview of the Polish mutual fund industry and investigates mutual fund performance using a survivorship bias controlled sample of 140 funds. The latter is done using the Carhart (1997) 4-factor asset-pricing model. In addition, we investigate whether Polish fund managers exhibit "hot hands", persistence in performance. Finally the influence of fund characteristics on risk-adjusted performance is considered. Our overall results suggest that Polish mutual funds on average are not able to add value, as indicated by their negative net alphas. Interestingly, domestic funds outperform internationally investing funds, which points at informational advantages of local over foreign investors. Finally, we detect strong persistence in mean returns up to 1 year. It is striking that "winning" funds are able to significantly beat the market, based on their significantly positive alpha's. These results deviate from studies on developed markets that conclude that even past winners are not able to significantly beat the market.
Mutual funds have emerged and rapidly developed since 2000 in China. This study tests empirically the impact of mutual funds’ ownership on firm performance in China, using a large sample for the period of 2001–2005. We find that equity ownership by mutual funds has a positive effect on firm performance. The result is robust to several measures of firm performance and various estimations. Our finding supports recent regulatory efforts in China to promote mutual funds as a corporate governance mechanism and suggests that pooling diffuse minority interests of individual shareholders who are prone to free-rider problems via mutual funds is beneficial.
This paper uses the perfect market segmentation setting in China's stock market to compare the information content of the stock trades of domestic and foreign investors. We study 76 firms that issue both A-shares (for domestic investors) and B-shares (for foreign investors) and compare the price discovery role of the two segmented markets in China. Before Feb 19, 2001, the A-share market led the B-share market in price discovery, as the signed volume and quote revision of the A-share market had strong predictive ability for B-share quote returns, but not vice versa. After Feb 19, 2001, because some domestic investors were allowed to invest in the B-share market, we find evidence for a reverse causality from the B-share to the A-share market. Nevertheless, the [Hasbrouck (1995). One security, many markets: determining the contributions to price discovery, Journal of Finance 50, 1175–1199.] information share analysis reveals that A-shares continue to dominate the price discovery process.
This paper identifies five common risk factors in the returns on stocks and bonds. There are three stock-market factors: an overall market factor and factors related to firm size and book-to-market equity. There are two bond-market factors, related to maturity and default risks. Stock returns have shared variation due to the stock-market factors, and they are linked to bond returns through shared variation in the bond-market factors. Except for low-grade corporates, the bond-market factors capture the common variation in bond returns. Most important, the five factors seem to explain average returns on stocks and bonds.
The recent split share structure reform in China involves the nontradable shareholders proposing a compensation package to the tradable shareholders in exchange for the listing rights of their shares. We find that state ownership (the major owners of nontradable shares) has a positive effect on the final compensation ratio. In contrast, mutual fund ownership (the major institutional owner of tradable shares) has a negative effect on the compensation ratio and especially in state-owned firms. The evidence is consistent with our predictions that state shareholders have incentives to complete the reform quickly and exert political pressure on mutual funds to accept the terms without a fight.
We examine the extent to which a fund's cash flows are affected by the stellar performance of other funds in its family —
and consequences of such spillovers. We show that star performance results in greater cash inflow to the fund and to other
funds in its family. Moreover, families with higher variation in investment strategies across funds are shown to be more likely
to generate star performance. We argue that spillovers may induce lower ability families to pursue star-creating strategies.
Consistent with our conjecture, families with high variation in investment strategies across funds significantly underperform
low-variation families.
This article introduces a new measure of portfolio performance and applies it to study the performance of a large sample of mutual funds. In contrast to previous studies of mutual fund performance, the measure used in this study employs portfolio holdings and does not require the use of a benchmark portfolio. It finds that the portfolio choices of mutual fund managers, particularly those that managed aggressive growth funds, earned significantly positive risk-adjusted returns in the 1976-85 period. Copyright 1993 by University of Chicago Press.
This article employs the 1975-84 quarterly holdings of a sample of mutual funds to construct an estimate of their gross returns. This sample, which is not subject to survivorship bias, is used in conjunction with a sample that contains the actual (net) returns of the mutual funds. In addition to allowing the authors to estimate the bias in measured performance that is due to the survival requirement and to estimate total transaction costs, the sample is used to test for the existence of abnormal performance. The tests indicate that the risk-adjusted gross returns of some funds were significantly positive. Copyright 1989 by the University of Chicago.
Efficient method of moments estimation techniques include many commonly used techniques, including ordinary least squares, two- and three-stage least squares, quasi maximum likelihood, and versions of these for nonlinear environments. For models estimated by any efficient method of moments technique, the authors define analogues to the maximum likeliho od based Wald, likelihood ratio, Lagrange multiplier, and minimum chi-squared statistics. They prove the mutual asymptotic equivalence of the four in an environment that allows for disturbances that are auto correlated and heteroskedastic. They also describe a very convenient way to test a linear hypothesis in a linear model. Copyright 1987 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.
Gruber (1996) and Zheng (1999) report that investors channel money toward mutual funds that subsequently perform well. Sapp and Tiwari (2004) find that this "smart money" effect no longer holds after controlling for stock return momentum. While prior work uses quarterly U.S. data, we employ a British data set of monthly fund inflows and outflows differentiated between individual and institutional investors. We document a robust smart money effect in the United Kingdom. The effect is caused by buying (but not selling) decisions of both individuals and institutions. Using monthly data available post-1991 we show that money is comparably smart in the United States. Copyright 2008 by The American Finance Association.
A previous study finds evidence to support selection ability among active fund investors for equity funds listed in 1982. Using a large sample of equity funds, I find evidence that funds that receive more money subsequently perform significantly better than those that lose money. This effect is short-lived and is largely but not completely explained by a strategy of betting on winners. In the aggregate, there is no significant evidence that funds that receive more money subsequently beat the market. However, it is possible to earn positive abnormal returns by using the cash flow information for small funds. Copyright The American Finance Association 1999.
This paper studies the flows of funds into and out of equity mutual funds. Consumers base their fund purchase decisions on prior performance information, but do so asymmetrically, investing disproportionately more in funds that performed very well the prior period. Search costs seem to be an important determinant of fund flows. High performance appears to be most salient for funds that exert higher marketing effort, as measured by higher fees. Flows are directly related to the size of the fund's complex as well as the current media attention received by the fund, which lower consumers' search costs. Copyright The American Finance Association 1998.
We examine the effect of information asymmetry on equity prices in the local A- and foreign B-share market in China. We construct measures of information asymmetry based on market microstructure models, and find that they explain a significant portion of cross-sectional variation in B-share discounts, even after controlling for other factors. On a univariate basis, the price impact measure and the adverse selection component of the bid-ask spread in the A- and B-share markets explains 44% and 46% of the variation in B-share discounts. On a multivariate basis, both measures are far more statistically significant than any of the control variables. Copyright 2008 by The American Finance Association.
We present a simple rational model to highlight the effect of investors' participation costs on the response of mutual fund flows to past fund performance. By incorporating participation costs into a model in which investors learn about managers' ability from past returns, we show that mutual funds with lower participation costs have a higher flow sensitivity to medium performance and a lower flow sensitivity to high performance than their higher-cost peers. Using various fund characteristics as proxies for the reduction in participation costs, we provide empirical evidence supporting the model's implications for the asymmetric flow-performance relationship. Copyright 2007 by The American Finance Association.
We use daily returns to compare the performance predictability of Bayesian estimates of mutual fund performance with standard frequentist measures. When the returns on passive nonbenchmark assets are correlated with fund holdings, incorporating histories of these returns produces a performance measure that predicts future performance better than standard measures do. Bayesian alphas based on the Capital Asset Pricing Model (CAPM) are particularly useful for predicting future standard CAPM alphas. Over our sample period, priors consistent with moderate to diffuse beliefs in managerial skill dominate more skeptical prior beliefs, a result that is consistent with investor cash flows. Copyright 2006 by The American Finance Association.
Does the "smart money" effect documented by Gruber (1996) and Zheng (1999) reflect fund selection ability of mutual fund investors? We examine the finding that investors are able to predict mutual fund performance and invest accordingly. We show that the smart money effect is explained by the stock return momentum phenomenon documented by Jegadeesh and Titman (1993) . Further evidence suggests investors do not select funds based on a momentum investing style, but rather simply chase funds that were recent winners. Our finding that a common factor in stock returns explains the smart money effect offers no affirmation of investor fund selection ability. Copyright 2004 by The American Finance Association.
Using a sample free of survivor bias, the author demonstrates that common factors in stock returns and investment expenses almost completely explain persistence in equity mutual funds' mean and risk-adjusted returns. Darryll Hendricks, Jayendu Patel, and Richard Zeckhauser's (1993) 'hot hands' result is mostly driven by the one-year momentum effect of Narasimham Jegadeesh and Sheridan Titman (1993), but individual funds do not earn higher returns from following the momentum strategy in stocks. The only significant persistence not explained is concentrated in strong underperformance by the worst-return mutual funds. The results do not support the existence of skilled or informed mutual fund portfolio managers. Copyright 1997 by American Finance Association.
Mutual funds represent one of the fastest growing type of financial intermediary in the American economy. The question remains as to why mutual funds and in particular actively managed mutual funds have grown so fast, when their performance on average has been inferior to that of index funds. One possible explanation of why investors buy actively managed open end funds lies in the fact that they are bought and sold at net asset value, and thus management ability may not be priced. If management ability exists and it is not included in the price of open end funds, then performance should be predictable. If performance is predictable and at least some investors are aware of this, then cash flows into and out of funds should be predictable by the very same metrics that predict performance. Finally, if predictors exist and at least some investors act on these predictors in investing in mutual funds, the return on new cash flows should be better than the average return for all investors in these funds. This article presents empirical evidence on all of these issues and shows that investors in actively managed mutual funds may have been more rational than we have assumed.