Itzhak Ben-David, Jiacui Li, Andrea Rossi, and Yang Song contribute to the literature on the behavior of individual investors with their July 2021 study “What Do Mutual Fund Investors Really Care About?”, published in the July 2021 issue of The Review of Financial Studies. They began by noting that while researchers agree that fund flows are strongly correlated with past performance, there is little agreement as to how to interpret this empirical phenomenon—are individual investors just exhibiting a recency bias in chasing returns, or do fund flows reflect investors learning about fund manager’s skill, continually assessing them and reallocating capital accordingly as theorized by Jonathan Berk and Richard Green in their 2004 study “Mutual Fund Flows and Performance in Rational Markets”?
To determine if individuals are just naïve performance chasers, unaware of the financial literature, or whether they are sophisticated investors Ben-David, Li, Rossi, and Song examined mutual fund flows spanning the period 1991-2017. Returns were analyzed in both raw terms as well as compared to the CAPM, the Fama-French three-factor model (market beta, size, and value), and the Fama-French four-factor model (adding momentum).
Following is a summary of their findings:
Individuals are simple decision makers who invest using easily obtainable information and do not adjust fund performance using asset pricing models.
Simple performance-chasing behavior explained the major flow patterns observed in the mutual fund market.
Individual investors do not engage in sophisticated learning about managers’ alpha-generating ability and do not distinguish between fund returns attributable to risk factor exposure versus alpha.
Morningstar star ratings and past unadjusted returns best explained which funds attracted flows, with both ratings and unadjusted returns having strong independent effects on flows—fund rankings based on alphas from common asset pricing models do not help to predict flows better than unadjusted returns-based rankings. In some econometric specifications, funds with high alphas received significantly lower flows than funds with high unadjusted returns.
Performance chasing occurs regardless of whether funds are actively managed or are passive index trackers.
Their findings led Ben-David, Li, Rossi, and Song to conclude:
“Our results are consistent with the view that, on average, households are homo sapiens with limited financial sophistication rather than hyperrational alpha-maximizing agents, as often assumed in the literature.”
“We find no evidence that investors treat alpha and beta returns differently.”
“households often engage in sub-optimal financial decision-making in a variety of domains (e.g., banking fees, credit cards, mortgages). This behavior has been attributed to several factors: poor financial literacy, extensive use of rules of thumb, and behavioral biases. Most households exhibit low levels of financial literacy, and many are not familiar with basic concepts of investing such as compounded interest, risk, diversification, and inflation. More broadly, households use a myriad of rules of thumbs to manage their financial affairs.”
“even highly educated and intelligent individuals (with SAT scores above the 98th percentile) chase uninformative index fund returns.”
Since the recent performance of mutual funds is not a good predictor of future returns, chasing returns is not a good strategy. The bottom line is that investors would be better served if instead of acting as homo sapiens, they acted as economists theorize, as rational homo economicus. Which are you?
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As Chief Research Officer for Buckingham Strategic Wealth and Buckingham Strategic Partners, Larry Swedroe spends his time, talent and energy educating investors on the benefits of evidence-based investing with enthusiasm few can match. Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has since authored seven more books: “What Wall Street Doesn’t Want You to Know” (2001), “Rational Investing in Irrational Times” (2002), “The Successful Investor Today” (2003), “Wise Investing Made Simple” (2007), “Wise Investing Made Simpler” (2010), “The Quest for Alpha” (2011) and “Think, Act, and Invest Like Warren Buffett” (2012). He has also co-authored eight books about investing. His latest work, “Your Complete Guide to a Successful and Secure Retirement was co-authored with Kevin Grogan and published in January 2019. In his role as chief research officer and as a member of Buckingham’s Investment Policy Committee, Larry, who joined the firm in 1996, regularly reviews the findings published in dozens of peer-reviewed financial journals, evaluates the outcomes and uses the result to inform the organization’s formal investment strategy recommendations. He has had his own articles published in the Journal of Accountancy, Journal of Investing, AAII Journal, Personal Financial Planning Monthly, Journal of Indexing, and The Journal of Portfolio Management. Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television shows airing on NBC, CNBC, CNN, and Bloomberg Personal Finance. Larry is a prolific writer and contributes regularly to multiple outlets, including Advisor Perspective, Evidence Based Investing, and Alpha Architect. Before joining Buckingham Wealth Partners, Larry was vice chairman of Prudential Home Mortgage. He has held positions at Citicorp as senior vice president and regional treasurer, responsible for treasury, foreign exchange and investment banking activities, including risk management strategies. Larry holds an MBA in finance and investment from New York University and a bachelor’s degree in finance from Baruch College in New York.
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