Mutual Fund Reputation and Investor's Reaction !! (My PhD Job Market Paper)

Does mutual fund's historic performance matter while investors determine their portfolios after observing a recent period's fund performance? In my PhD thesis, I solve this interesting question using a large dataset of US equity mutual funds. Before starting with the paper, I had this intuitive notion that a good history mutual fund can escape a one-off bad performance since investors are more likely to attribute this to a bad luck rather than lack of skill. Such behavior is also supported by behavioral traits such as confirmation bias where investors tend to disregard the new information if it does not match with their prior information. So a bad performance by a good history fund is exactly a type of information they 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 as compared to a bad-history fund. This left me with a small puzzle on my hands. Just to state findings complete, I also find that a good performance by a good-history fund attracts a lot more percentage inflows as compared to a bad-history fund. In summary, good-history funds experience very sensitive capital flows to their recent performance but bad-history funds neither lose lot of money on bad performance nor gain any significant capital with a reasonable performance. Just to give sense of magnitude, I report the numbers from my regression analysis. Consider a worst fund and a best fund. Worst fund has a bad history and also performs badly this period. On the other hand a best fund has an excellent history and it also performs nicely this period. Then best fund receives 50\% (as a percentage of asset size) as compared to worst fund. Out of which one-fifth can be attributed to the fact that best fund has a better recent period performance, one-tenth to the fact that it starts the period with higher reputation due to better historic performance, but whole of the remaining two-third to the fact that it performed well this period and it also had a good reputation to start with. This last effect is the joint effect and shows that the importance of the recent period's performance grows with good historic performance.

So there are two immediate questions: First is why this result is interesting? Second how one can explain this counter-intuitive evidence? To answer first question, it's important to 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 winner funds and drop out of recent losing funds. But what my data shows is that the extent of this tendency is virtually determined by the historic performance. The good-history funds experiences this return chasing type of investor's behavior, but flows in and out of a bad-history fund are insensitive. So my results are important to qualify the applicability of this return chasing notion. Second important reason is that the investor's reaction determines the risk that a fund manager is ready to undertake. To this extent, good-history and bad-history funds can showcase very different risk taking appetite. I present the evidence on risk taking in a second post.

Coming to the second question, I have a simple story to explain these results. Imagine a world with two types of investors: Some investors are more attentive to the information than others. In this world, attentive investors always update their beliefs about the fund manager after each performance and shift out if fund keeps on performing badly. Necessarily they shift 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 by inattentive investors in large part. This implies that a bad-performance by a good-history fund will be penalized more.

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