Extrapolative Expectations and Asset Returns: Evidence from Chinese Mutual Funds

Abstract

We study mutual funds' stock market expectation formation and its implications for asset returns using a novel text-based measure of beliefs inferred from Chinese fund reports. Funds extrapolate from recent stock market and fund returns when reporting expectations about future market performance, with more recent returns receiving greater weight. This extrapolative belief is not systematically biased but overextrapolation is: consensus expectations positively predict future market returns, whereas the degree of extrapolation negatively predicts future returns. Moreover, we find a positive time-series relation between expectations and performance for a given fund unconditionally. However, in the cross-section, this relation holds only when funds align their portfolio adjustments with their expectations and when those expectations are accurate.

Keywords: Mutual fund, Stock market expectation, Extrapolation, Fund performance, Textual analysis