Mutual Fund Investor Learning and the Economic Cost of Chasing Alpha

67 Pages Posted: 29 Apr 2018

See all articles by Geoffrey C. Friesen

Geoffrey C. Friesen

University of Nebraska at Lincoln - Department of Finance

Viet Nguyen

University of Nebraska at Lincoln - Department of Finance, Students

Date Written: October 31, 2018

Abstract

This study analyzes how mutual fund investor behavior has changed over time, and the associated impact on investor returns. First, we find that investor return-chasing behavior has essentially disappeared starting in 2011, while investor flows have become more sensitive to expenses, past risk and alpha. Investors now pay more attention to fund characteristics that have the potential to improve future performance (e.g. risk, alpha and expenses), and less attention to characteristics that don’t (e.g. past returns). We then ask whether this means that money has become “smarter”, that is, whether the increased attention to fund alphas has improved investors’ realized performance. It has not. In fact, investors’ focus on alpha is actually more detrimental than their previous focus on past returns. To understand why, we develop and present a decomposition which captures the economic impact of each incremental dimension of investor behavior. The conclusion that paying attention to alpha is detrimental is puzzling given the existing evidence that past and future alphas have a positive correlation in the cross-section. But as we point out, past alphas are strongly and negatively correlated with future alphas at the individual fund level, which is the level where most mutual fund customers invest. Investors do realize some benefit from choosing high-alpha funds (smart money), but time their cash flows poorly by investing in those funds after periods with the highest realized alphas (dumb money). 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.

Keywords: Mutual Fund Investor Behavior, Return-chasing, Smart Money, Dumb Money, Alpha Persistence

JEL Classification: G11, G23

Suggested Citation

Friesen, Geoffrey C. and Nguyen, Viet, Mutual Fund Investor Learning and the Economic Cost of Chasing Alpha (October 31, 2018). Available at SSRN: https://ssrn.com/abstract=3160271 or http://dx.doi.org/10.2139/ssrn.3160271

Geoffrey C. Friesen (Contact Author)

University of Nebraska at Lincoln - Department of Finance ( email )

Department of Finance
Lincoln, NE 68588-0489
United States
402-472-2334 (Phone)

Viet Nguyen

University of Nebraska at Lincoln - Department of Finance, Students ( email )

Lincoln, NE
United States

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