Sentimental mutual fund flows

• DOI: http://doi.org/10.1111/fire.12201
• Published date: 01 November 2019
• Author: George J. Jiang,H. Zafer Yüksel
• Date: 01 November 2019

DOI: 10.1111/fire.12201

ORIGINAL ARTICLE

Sentimental mutual fund flows

George J. Jiang1H. Zafer Yüksel2

1Department of Finance and Management

Science, WashingtonState University, Pullman,

Washin gton

2Accounting and Finance Department, University

of Massachusetts Boston, Boston, Massachusetts

Correspondence

GeorgeJ. Jiang, Department of Finance and

ManagementScience, Carson College of Busi-

ness,Washington State University, Pullman,WA

99164.

Email:george.jiang@wsu.edu

Abstract

Weshow that many stylized empirical patterns for mutual fund flows

aredriven by investor sentiment. Specifically, when sentiment is high,

investors exhibit a stronger tendency of chasing past fund perfor-

mance; fund flows are less sensitive to fund expenses; and investors

are attracted more to funds with sheer visibility.Moreover, the well-

documented positive relation between fund flows and future fund

performance is significant only during high sentiment periods and is

mainly drivenby expected component of fund flows. Finally, we show

thatmutual fund investors exhibit a significantly negative timing abil-

ity at the individual fund level when sentiment is high.

KEYWORDS

flow-performance relation, fund expenses, fund performance, fund

visibility, investor sentiment, investortiming mutual fund flows

JEL CLASSIFICATIONS

G11, G02, G23

1INTRODUCTION

The literature documents that money flows to mutual funds are related to a number of fund characteristics. Much

of the finding reinforces the notion that individual investors are unsophisticated in their investment decisions. For

instance, mutual fund investors tend to chase funds with strong past performance, despite the fact that the literature

findsevidence of performance persistence only for poorly performing funds (Carhart, 1997).1The literature shows that

benchmark-adjusted fund performance fails to justify fund expenses(Carhart, 1997; Gruber, 1996), yet some investors

actually pick funds with high fees.2Moreover,investors are attracted to funds with high visibility due to advertising or

brand recognition, although very often these characteristics are poor signals of fund manager skills or fund perfor-

mance.3Despite the corroborating evidence on behavioral biases of mutual fund investors,the literature also argues

that some stylized findings on mutual fund flows may be driven by rational decisions. For instance, Berk and Green

1For literature on the relation between flows and past fund performance, see Chevalierand Ellison (1997), Goetzmann and Peles (1997), Sirri and Tufano

(1998),and Huang, Wei, and Yan (2007).

2Sirriand Tufano (1998) find evidence that mutual fund investors pay attention to the cost of investment.Elton, Gruber, and Busse (2004) and Barber, Odean,

and Zheng (2005) show that mutual fund investors fail to minimize expenses of investment.Bailey, Kumar, and Ng (2011) show that investors with strong

behavioralbiases actually select funds with high expenses.

3Forliterature on the relation of fund flows with marketing and brand recognition, see Jain and Wu (2000), Sirri and Tufano (1998), and Huang et al. (2007).

Financial Review.2019;54:709–738. wileyonlinelibrary.com/journal/fire c

2019 The Eastern Finance Association 709

710 JIANG ANDYÜKSEL

(2004) argue that it is rational for mutual fund investors to chase funds with strong past performance. In their model,

rational investors form beliefs about fund manager skill based on past performance and allocate their capital toward

recentwinners. Furthermore, several studies document a “smart-money” effect in mutual fund flows.4That is, investors

have the ability to identify fund managers with superior skills and invest accordingly by moving money toward good

performers and away from poor performers.

In this study, we investigate the extentto which the stylized findings on mutual fund flows are driven by investor

sentiment, that is, investors’ subjective view of market conditions. Previous studies show that sentiment directly

affects the participation of individual investors and their asset allocation decisions which, in turn, have a significant

effect on market returns and individual stock returns (Baker & Wurgler, 2006; Brown & Cliff, 2005; Kumar & Lee,

2006; Lemmon & Portniaguina, 2006; Stambaugh, Yu,& Yuan, 2012; Yu & Yuan, 2011). The literature also shows that

mutual fund investors are particularly subject to behavioral biases and sentiment swings (Bailey et al., 2011; Capon,

Fitzsimons, & Prince, 1996; Wilcox, 2003). Given that mutual fund investmentsrepresent a substantial portion of U.S.

householdportfolios and investor asset allocation decisions have a direct effect on asset prices, it is important to under-

stand mutual fund selection decisions by investors.5

Different from the literature on aggregated fund flows, the focus of our study is the impact of sentiment on

investors’ fund selection, namely how the relations between fund characteristics and fund flows vary during differ-

ent sentiment periods. Specifically, we are interested in the following questions. First, do investors exhibitthe same

tendency of chasing past performance across different sentiment periods? As noted earlier,while chasing past perfor-

mance is generally viewed as evidenceof behavioral bias, it may also be consistent with rational models (Berk & Green,

2004). Todistinguish trend chasing versus the ability of identifying skilled fund managers, we use both naïve measure

(raw fund return) and more sophisticated measure (risk-adjusted fund return) of fund performance in our analysis. If

performance chasing is rational and driven by fund manager skill, we expect that fund flows are significantly related

to risk-adjusted fund returns during both high and low sentiment periods (Barber,Huang, & Odean, 2016; Berk & Van

Binsbergen, 2016; Del Guercio & Reuter, 2014). On the other hand, if performance chasing is driven by unsophisti-

cated investors, we should observe a stronger relation between fund flows and the naïve performance measure when

sentiment is high. Second, are investors equally sensitive to the cost of investingin mutual funds across different sen-

timent periods? If investors fully understand the effect of expenses on fund returns, we should see no variation in the

sensitivity of fund flows to fund expenses across different sentiment periods. However,if sentiment-driven investors

do not fully understand the cost of investing in mutual funds, we expect a weaker sensitivity of fund flows to fund

expenses during high sentiment periods. Third, are investors equally attractedto funds with high visibility across dif-

ferent sentiment periods? Fund visibility reduces search costs and information barrier for investors, especially unso-

phisticated investors (Huang et al., 2007; Sirri & Tufano, 1998). Nevertheless,while marketing effort increases fund

visibility,it is shown to have a negative impact on fund performance (Bergstresser, Chalmers, & Tufano,2009; Gil-Bazo

& Ruiz-Verdu, 2009). On the other hand, certain proxiesof fund visibility measures, for example, star manager and

fund family size, may be related to fund manager skill or fund performance. In our empirical analysis, we carefully dis-

tinguish visibility measures that are potentially related to fund manager skills and other sheer visibility measures that

have no effect or even a negativeeffect on fund performance. We examine how the relations between fund flows and

these visibility measures vary across different sentiment periods and draw inference on the behavior of mutual fund

investors.

Moreover, we are interested in whether the well-documented flow-performance relation varies across different

sentiment periods. Gruber (1996) and Zheng (1999) interpret the positive relation between fund flows and future

fund performance as evidence of smart-money effect. Several studies offer a competing explanation based on flow-

induced performance. For example, Wermers (2003) finds that flow-related buying pushes up stock prices beyond

4Forliterature on the “smart-money” effect of mutual fund flows, please refer to Gruber (1996), Sapp and Tiwari (2004), Zheng (1999), and Keswani and Stolin

(2008).

5Despitethe growth of exchange-traded funds over the past decades, mutual fund remains an important investment vehicle for U.S.households. According to

InvestmentCompany Institute Fact Book, an estimated 94 million individual investors (44% of all U.S. households) owned mutual funds in 2016. The median

mutualfund assets held by fund-owning households was $125,000.