Models or Stars: The Role of Asset Pricing Models and Heuristics in Investor Risk Adjustment

57 Pages Posted: 11 Dec 2018

See all articles by Richard B. Evans

Richard B. Evans

University of Virginia - Darden School of Business

Yang Sun

Brandeis University- International Business School

Date Written: November 20, 2018

Abstract

We examine how third party ratings and mandatory benchmark disclosure affect aggregate risk adjustment by retail investors. Morningstar changed its ratings methodology in June 2002. Before the change, the ratings were based on a risk-adjusted performance ranking of all US equity funds and highly correlated to CAPM alphas. After the change, the ranking was calculated within size and book-to-market categories, effectively controlling for these exposures and increasing the rating's correlation to Fama-French (FF3) alphas. Flows strongly correlate with CAPM alphas before the change, but are strongly related to FF3 alphas after. Flows to a matched subset of institutional separate accounts with the same manager and strategy strongly correlate with FF3 before and after the change, but are unrelated to CAPM. Over the broader time period, we find investor flows increasingly respond to FF3 alphas, and this broad trend is explained in part by the ratings' methodology change and improvements in self-declared fund benchmarks, the latter as a result of greater competition. Our results suggest that instead of employing asset pricing models, the average retail investor appears to rely on third-party certification and fund benchmark disclosure to indirectly risk-adjust. Moreover, improvements in rating methodologies and increasing competition drive higher level of sophistication in the risk-adjustment model implied by retail fund flows.

Keywords: mutual fund flows, risk adjustment, retail and institutional investors, benchmarks, quality disclosure

JEL Classification: G11, G23, D14, D83

Suggested Citation

Evans, Richard B. and Sun, Yang, Models or Stars: The Role of Asset Pricing Models and Heuristics in Investor Risk Adjustment (November 20, 2018). Available at SSRN: https://ssrn.com/abstract=3287997 or http://dx.doi.org/10.2139/ssrn.3287997

Richard B. Evans (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4030 (Phone)
434-243-7680 (Fax)

HOME PAGE: http://faculty.darden.virginia.edu/evansr/

Yang Sun

Brandeis University- International Business School ( email )

415 South Street MS032
Waltham, MA 02453
United States
781-736-4708 (Phone)

HOME PAGE: http://www.brandeis.edu/facultyguide/person.html?emplid=c82c39a3be3416bc5844f2049d540871fd331eaf

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