How Investors Interpret Past Fund Returns

Abstract

Several recent papers find a convex relation between past returns and fund flows of open-end mutual funds. We show this pattern to be consistent with fund incentives, in that funds will discard exactly those strategies which underperform. Past returns contain less information about the future performance of funds which change strategies, so fund flows are less sensitive to past returns when past returns are lower. Evidence from the performance persistence literature supports this view, though the behavior of investors in the very worst funds remains anomalous. We test two implications of our story using a new data set of daily mutual fund returns from Micropal and manager-change dates from the CRSP mutual fund data set. The first implication is that strategy changes occur only after bad fund performance. The other is that poor performers who change strategy enjoy a larger performance improvement than poor performers who do not. Using change in risk loadings from a four factor model and a manager-change variable as proxies for change in strategy, we find empirical support for both these implications.

JEL Classification: G11, G23