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Smart Fund Managers? Stupid Money?

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Author Info

  • Dan Bernhardt

    ()
    (Department of Economics, University of Illionis)

  • Ryan Davies

    ()
    (ICMA Centre, University of Reading)

  • Harvey Westbrook Jr.

    ()
    (Securities and Exchange Commission, Washintgon DC)

Abstract

We develop a theoretical model of a mutual fund manager’s investment decision that incorporates three well-known observations: (i) past fund performance influences subsequent net fund inflows; (ii) fund manager compensation rises with total assets under management; (iii) trading has short-run price impacts. These observations provide fund managers the incentive to distort investment of new cash inflows toward stocks in which the fund holds larger positions. We show that this leads to the empirically observed short-run persistence and long-run reversal in fund performance. It also explains why mutual funds tend to be relatively undiversified and appear to exhibit clairvoyant stock selection.

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Bibliographic Info

Paper provided by Henley Business School, Reading University in its series ICMA Centre Discussion Papers in Finance with number icma-dp2002-19.

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Length: 32 pages
Date of creation: Sep 2002
Date of revision: Jul 2003
Handle: RePEc:rdg:icmadp:icma-dp2002-19

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Related research

Keywords: turn-of-quarter effect; painting the tape; mutual fund performance; investment distortion;

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References

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  1. Lakonishok, Josef, et al, 1991. "Window Dressing by Pension Fund Managers," American Economic Review, American Economic Association, vol. 81(2), pages 227-31, May.
  2. Chan, Louis K C & Lakonishok, Josef, 1995. " The Behavior of Stock Prices around Institutional Trades," Journal of Finance, American Finance Association, vol. 50(4), pages 1147-74, September.
  3. Mark M. Carhart & Ron Kaniel & David K. Musto & Adam V. Reed, 2002. "Leaning for the Tape: Evidence of Gaming Behavior in Equity Mutual Funds," Journal of Finance, American Finance Association, vol. 57(2), pages 661-693, 04.
  4. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
  5. Brown, Stephen J & Goetzmann, William N, 1995. " Performance Persistence," Journal of Finance, American Finance Association, vol. 50(2), pages 679-98, June.
  6. Judith A. Chevalier & Glenn D. Ellison, 1995. "Risk Taking by Mutual Funds as a Response to Incentives," NBER Working Papers 5234, National Bureau of Economic Research, Inc.
  7. Dan Bernhardt & Eric Hughson, 1991. "Intraday Trade in Dealership Markets," Working Papers 841, Queen's University, Department of Economics.
  8. Edelen, Roger M., 1999. "Investor flows and the assessed performance of open-end mutual funds," Journal of Financial Economics, Elsevier, vol. 53(3), pages 439-466, September.
  9. Keim, Donald B. & Madhavan, Ananth, 1997. "Transactions costs and investment style: an inter-exchange analysis of institutional equity trades," Journal of Financial Economics, Elsevier, vol. 46(3), pages 265-292, December.
  10. Chan, Louis K C & Lakonishok, Josef, 1997. " Institutional Equity Trading Costs: NYSE versus Nasdaq," Journal of Finance, American Finance Association, vol. 52(2), pages 713-35, June.
  11. Goetzmann, William N & Peles, Nadav, 1997. "Cognitive Dissonance and Mutual Fund Investors," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 20(2), pages 145-58, Summer.
  12. Edelen, Roger M. & Warner, Jerold B., 2001. "Aggregate price effects of institutional trading: a study of mutual fund flow and market returns," Journal of Financial Economics, Elsevier, vol. 59(2), pages 195-220, February.
  13. Ippolito, Richard A, 1992. "Consumer Reaction to Measures of Poor Quality: Evidence from the Mutual Fund Industry," Journal of Law and Economics, University of Chicago Press, vol. 35(1), pages 45-70, April.
  14. Easley, David & Kiefer, Nicholas M & O'Hara, Maureen, 1997. "One Day in the Life of a Very Common Stock," Review of Financial Studies, Society for Financial Studies, vol. 10(3), pages 805-35.
  15. Erik R. Sirri & Peter Tufano, 1998. "Costly Search and Mutual Fund Flows," Journal of Finance, American Finance Association, vol. 53(5), pages 1589-1622, October.
  16. Chen, Hsiu-Lang & Jegadeesh, Narasimhan & Wermers, Russ, 2000. "The Value of Active Mutual Fund Management: An Examination of the Stockholdings and Trades of Fund Managers," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 35(03), pages 343-368, September.
  17. Malkiel, Burton G, 1995. " Returns from Investing in Equity Mutual Funds 1971 to 1991," Journal of Finance, American Finance Association, vol. 50(2), pages 549-72, June.
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Cited by:
  1. Chang, Rosita P. & Rhee, S. Ghon & Stone, Gregory R. & Tang, Ning, 2008. "How does the call market method affect price efficiency? Evidence from the Singapore Stock Market," Journal of Banking & Finance, Elsevier, vol. 32(10), pages 2205-2219, October.
  2. Tālis J. Putniņš, 2012. "Market Manipulation: A Survey," Journal of Economic Surveys, Wiley Blackwell, vol. 26(5), pages 952-967, December.
  3. Jonathan B. Berk & Richard C. Green, 2004. "Mutual Fund Flows and Performance in Rational Markets," Journal of Political Economy, University of Chicago Press, vol. 112(6), pages 1269-1295, December.
  4. Bernhardt, Dan & Davies, Ryan J., 2005. "Painting the tape: Aggregate evidence," Economics Letters, Elsevier, vol. 89(3), pages 306-311, December.
  5. Comerton-Forde, Carole & Putnins, Talis J., 2011. "Measuring closing price manipulation," Journal of Financial Intermediation, Elsevier, vol. 20(2), pages 135-158, April.

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