Are Investors Becoming Better at Fund Picking?
No, investors seem to learn from past mistake of chasing past performace but are prone to new mistakes – especially to chasing past alpha:
Authors: Friesen, Nguyen
Title: The Economic Impact of Mutual Fund Investor Behaviors
This study analyzes how the determinants of mutual fund investor cash flows have changed over time, and the associated impact on investor returns. Using data from 1992-2016 we find that investor return-chasing behavior essentially disappeared starting in 2011. Investor flows have become more sensitive to expenses, past risk and alpha. Investors are paying more attention to fund characteristics that matter (e.g. risk, alpha and expenses), and less attention to characteristics that don’t (e.g. past returns). Nevertheless, the average investor dollar-weighted return is about 1.2% below the average buy-and-hold return in their underlying mutual fund nearly every year in our sample, suggesting consistently poor timing ability over the entire period. We decompose the economic impact of investor behaviors on investor returns and find that investors’ focus on alpha is actually more detrimental than their previous focus on past returns. Investors do benefit from choosing high-alpha funds (smart money), but poorly time their cash flows by investing in those funds after periods with the highest realized alphas (dumb money). The dumb money effect dominates the smart money effect for the simple reason that at the fund level, past alphas are strongly and negatively correlated with future alphas. Although past alphas are positively correlated to future alphas in the pooled cross-section of mutual fund data, this result does not hold at the individual fund level, which is the level where most mutual fund customers invest. Overall, our results suggest that mutual fund investors know that alpha is important, but have not yet learned how to effectively integrate this knowledge into their investment decisions.
Notable quotations from the academic research paper:
"In this study, we examine how the determinants of mutual fund investor cash flows have changed over the past twenty-five years, the economic impact of these changes on investor returns, and ask what these changes tell us about learning among these investors.
Our contributions are of three-fold: first, we document several changes in investor behaviors in the mutual fund industry over our sample period of 1992-2016: investor return- chasing behavior has essentially disappeared starting in 2011; investor flows have become much more sensitive to expenses and past risk; and that the sensitivity of cash flows to fund alpha has been steady or increasing throughout the entire period. To our knowledge, this is the first study to directly measure and report these time-trends in investor behavior.
Second, we develop and present a decomposition which captures the economic impact of each incremental change in behavior. We then estimate the economic impact and for each behavior, specifically the return- chasing, the alpha-chasing, and risk sensitivity behaviors. Among other things, we find that investors’ focus on alpha is actually more detrimental than their previous focus on past returns.
Third, we show that once we control for variation in average alpha levels across funds, future alphas are negatively correlated with past alphas at the fund level. The results support the presence of both a “smart money effect” (which arises from investors chasing alphas, which are positively correlated in the pooled cross-section) and a “dumb money effect” (which arises from investors chasing alphas, which are negatively autocorrelated at the fund level). The economic impact of the “dumb money” effect dominates that of the “smart money” effect. Paying attention to alpha in the current manner is worse than not paying attention to alpha at all.
The claim that future alphas are negatively correlated with past alphas is at odds with the findings of several studies, including a study done by Elton, Gruber, and Blake (2011), which reports a positive correlation between past and future alphas. We show that while past and future alphas are positively correlated in the pooled cross-section, this relationship breaks down at the fund level, where most retail investors actually invest. At the fund level, past alphas are strongly and negatively correlated with future alphas, regardless of the time-horizon or factor-model used. This is why chasing past alphas is detrimental to investor returns.
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