Mutual Fund Switching Lowers Investors' Returns
"Individual investors in fact perform so poorly that one could use their mutual fund reallocations to predict future stock returns."
It is a common practice for individual investors to shift money from one mutual fund to another in pursuit of better returns. In regard to future stock prices, however, Andrea Frazzini and Owen Lamont declare that such practice is nothing short of foolish. In Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns (NBER Working Paper No. 11526), the researchers demonstrate that "individual investors have a striking ability to do the wrong thing." They assert that individual investors in fact perform so poorly that one could use their mutual fund reallocations to predict future stock returns.
Frazzini and Lamont estimate that in 1999 for example investors placed $37 billion in Janus funds, which were heavy in high-flying tech stocks, but only $16 billion in Fidelity funds. By 2001, however, investors pulled about $12 billion out of Janus and added about $31 billion to Fidelity. This shift caused losses to mutual fund investors as Janus and tech funds declined after 1999.
According to some theories, certain individual investors can identify skilled fund managers and accordingly place their investments with them. Thus, in contrast to the Janus experience, flows should be positively correlated with future returns. Indeed, the evidence indicates that short-term performance of funds with inflows is significantly better than those with outflows, which suggests that mutual fund investors have selection ability. But Frazzini and Lamont are interested in the long-term effect, and how on net investors are affected by fund flows.
To discern the patterns, the researchers calculate the mutual fund ownership of a stock attributable to reallocation decisions as reflected in fund flows. At the end of 1999, for example, 18 percent of the outstanding Cisco shares were owned by mutual funds. From their sample of funds, Frazzini and Lamont believe that 3 percent of these shares were attributable to disproportionately high inflows over the previous three years. This means that if flows had occurred proportionately to asset value (instead of disproportionately to funds like Janus), the level of mutual fund ownership would have been only 15 percent. The 3 percent difference is the researchers' measure of investor sentiment, which they then test as a predictor of differential return on stocks.
As suggested by the Janus and Cisco examples in 1999, the researchers determine that on average from 1980 to 2003, retail investors put their money into funds that invested in stocks with low future returns. But to gain high returns, it is best to do just the opposite. Frazzini and Lamont find that mutual fund investors experience total returns that are significantly lower because of their reallocations. Therefore, mutual fund investors are "dumb" in that their reallocations lose them money. Frazzini and Lamont call this predictability the "dumb money" effect.
This dumb money effect is related to the value effect. Money flows into mutual funds that own growth stocks and flows out of mutual funds that own value stocks, reflecting the fact that investors tend to favor mutual funds with high recent returns. This challenges risk-based theories of the value effect, which would need to explain why one class of investors is selling "high risk" value stocks and buying "low risk" growth stocks. Frazzini and Lamont add that while the dumb money effect is statistically distinct from the value/reversal effect, it is evident that these two effects are highly related.
Moreover, Frazzini and Lamont note a correlation between demand by individuals and supply from firms. When individuals buy more stock of a specific company via mutual fund inflows, the company increases the number of shares outstanding. This supports the view that individual investors are dumb while smart firms exploit their demand for shares.
By analyzing the relation between flows and mutual fund returns, Frazzini and Lamont find mixed evidence on a smart money effect of short-term flows positively predicting short-term returns. This could be because investors detect some short-term manager skills. Or it could be the result of mutual fund inflows actually boosting prices. Or it may merely be that by chasing past returns, investors are stumbling onto a valuable momentum strategy. Whatever the explanation, the higher short-term returns clearly are not effectively accruing to individual investors, and as a whole investors harm themselves in the long run by their reallocations.
On the matter of issuers and flows, the researchers conclude that individual investors often trade poorly, largely because their trades are executed through their dynamic allocation across mutual funds via financial institutions. But it appears the financial institutions are not exploiting the individuals nearly as much as the non-financial institutions that issue and repurchase stock. As stocks go in and out of favor with individuals, firms exploit their sentiments by trading in the opposite direction, selling stock when individuals want to buy it. A fund manager may be skilled at stock picking, but this is swamped by such actions as retail investors switching their money across funds. What Frazzini and Lamont observe are financial institutions acting like "passive intermediaries who facilitate trade between dumb money, individuals and smart money, firms.
-- Matt NesviskyThe Digest is not copyrighted and may be reproduced freely with appropriate attribution of source.