Fund Manager Overconfidence and Investment Performance: Evidence from Mutual Funds

Abstract

The purpose of this paper is to investigate to what extent mutual fund managers, as an important and representative group of professional investors, are prone to overconfidence and associated behavioural biases such as self-serving attribution. More importantly, we explore how these psychological attributes may have any bearing on investment performance. The fundamental question is why, how, and through which mechanisms does overconfidence affect investment performance, if at all. We measure managerial overconfidence by content analysing the narratives of reports fund managers write to their investors, and by using a range of proxies including overoptimism, excessive certainty and excessive self-reference. We study a large sample of US actively managed equity mutual funds during the 2003-09 period. The cross-sectional variations in this sample demonstrate that superior past performance boosts managerial overconfidence as measured by a number of proxies. Importantly, our findings also suggest that excessive overconfidence is associated, to a large extent, with diminished future investment returns in the 12 months following the publication of the annual report. This effect is robust across different investment styles, although it appears to be stronger among growth-oriented funds. A closer investigation reveals an overall inverted-U relationship between fund manager overconfidence and subsequent investment performance. Furthermore, a hedging strategy based on shorting funds with abnormally overconfident managers and going long in funds with normally confident managers yields positive average returns after controlling for Carhart factors.

Keywords: fund manager behaviour, overconfidence, mutual fund performance, investor psychology

JEL Classification: G12, G20