Why Do Mutual Fund Investors Do What They Do?

For several decades, individual investors have been moving billions of dollars in and out of thousands of mutual funds. The question is: why? Andrea Rossi, assistant professor of finance in the Eller College of Management, tries to answer this question with new research that is forthcoming in the Review of Financial Studies.

In an article titled “What do Mutual Fund Investors Really Care About?” Rossi and his coauthors analyzed two decades of money flows to more than 3,500 funds in order to understand what drives these flows.

One potential explanation for why investors move money across funds is that they are seeking the holy grail of financial markets: alpha, that is, superior risk-adjusted performance. According to this view, investors look at past fund returns to understand whether a given fund manager has the skill to produce alpha and invest accordingly. This view is popular with “rational” financial market researchers, since it describes how investors should behave. The new research, however, paints a rather different picture.

Because households hold the majority of mutual fund assets, Rossi and his co-authors tested whether naive performance chasing explains mutual fund flows better than alpha-seeking behavior. To motivate their hypothesis, the authors note that, in general, household investors appear to “have limited financial literacy, limited access to information, and limited ability to process information.”

The results show that mutual fund investors appear to naively chase past performance by means of simple signals—especially past unadjusted returns and Morningstar’s star ratings. There was no clear evidence that investors pay attention to whether past returns were generated by managerial skill or exposure to systemic factors.

Moreover, the article compares money flows in the actively-managed fund space with those to passive index-tracking funds.

“Paradoxically, performance-chasing patterns of similar magnitude also hold for passive index funds,” says Rossi, suggesting that “investors fail to distinguish between fund performance attributable to active management and fund performance that simply reflects market returns.”

The study concludes that “there is no evidence that investors allocate capital to funds based on the exposure to the market factor or to any other risk factor. Mutual fund flows indicate that investors pursue easy-to-follow signals, which are ultimately not informative about the ability of fund managers to deliver superior performance.”

This research is co-authored by Itzhak Ben-David from The Ohio State University and NBER, Jiacui Li from the University of Utah and Yang Song from the University of Washington.

This article originally appeared on News Wise.

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