Mutual Fund’s Reputation and Investor’s Reaction toRecent Performance

Apoorva JavadekarBoston University

February 6, 2016

Does mutual fund’s historic performance matter while investors determine their port-folios after observing a recent period’s fund performance? In my PhD thesis, I solve thisinteresting question using a large dataset of US equity mutual funds. Before starting withthe paper, I had this intuitive notion that a good history mutual fund can escape a one-offbad performance since investors are more likely to attribute this to a bad luck rather thanlack of skill. Such behavior is also supported by a behavioral traits such as confirmation biaswhere investors tend to disregard the new information if it does not match with their priorinformation. So a bad performance by a good history fund is exactly a type of informationthey are ready to ignore. But what I found in the data was exactly opposite to this intuition:A bad performance by a good-history fund experiences more fraction of capital outflow ascompared to a bad-history fund. This left me with a small puzzle on my hands. Just tostate findings complete, I also find that a good performance by a good-history fund attractsa lot more percentage inflows as compared to a bad-history fund. In summary, good-historyfunds experience very sensitive capital flows to their recent performance but bad-historyfunds neither lose lot of money on bad performance nor gain any significant capital witha reasonable performance. Just to give sense of magnitude, I report the numbers from myregression analysis; Consider a worst fund and a best fund. Worst fund has a bad historyand also performs badly this period. On the other hand a best fund has an excellent historyand it also performs nicely this period. Then best fund receives 50% ( as a percentage ofasset size) as compared to worst fund. Out of which one-fifth can be attributed to the factthat best fund has a better recent period performance, one-tenth to the fact that it starts theperiod with higher reputation due to better historic performance, but whole of the remainingtwo-third to the fact that it performed well this period and it also had a good reputation tostart with. This last effect is the joint effect and shows that the importance of the recentperiod’s performance grows with good historic performance.

So there are two immediate questions: First is why this result is interesting? Secondhow one can explain this counter-intuitive evidence? To answer first question, it’s importantto know what was known till the day about capital flows in and out of a mutual fund.The notion of ’return chasing’ was pervasive: meaning that investors chase recent winnerfunds and drop out of recent losing funds. But what my data shows is that the extent ofthis tendency is virtually determined by the historic performance. The good-history funds

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experiences this return chasing type of investor’s behavior, but flows in and out of a bad-history funds are insensitive. So my results are important to qualify the applicability of thisreturn chasing notion. Second important reason is that the investor’s reaction determine therisk that a fund manager is ready to undertake. To this extent, good-history and bad-historyfunds can showcase very different risk taking appetite. I present the evidence on risk takingin a second post.

Coming to the second question, I have a simple story to explain this results. Imagine aworld with two types of investors: Some investors are more attentive to the information thatothers. In this world, attentive investors always update their beliefs about the fund managerafter each performance and shift out if fund keeps on performing badly. Necessarily theyshift to good performing funds. Only inattentive investors stick with badly performing funds.So good-history funds are owned by attentive investors and bad-history funds are owned byinattentive investors in large part. This implies that a bad-performance by a good-historyfund will be penalized more.

In summary, these results give a very different picture than what was thought to be trueearlier and importantly can help funds managers understand the type of investor behaviorthey are likely to face given their historic performance.

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