Individual investors in mutual funds

Question 1

What kinds of portfolios do they choose to hold?

Question 2

How do they trade over time?

Question 3

What are the applications of behavioural finance and individual investor?

Answer 3

Applications of behavioral finance:
Insufficient diversification.
Naive diversification.
Excessive trading.
The buying decision: attention effect. The selling decision: disposition effect.

Question 4

Insufficient diversification

Answer 4

Definition: Investors diversify their portfolio holdings much less than is recommended by normative models of portfolio choice.
Manifestations:
1. Home bias and local investments:
- Overweight assets from home country.
- Overweight local assets within the same country.
2. Investing in employer’s company:
- Enron employees had 62% of their retirement plan assets invested in company stock at the end of 2000.
3. Both outcomes expose investors to idiosyncratic local risk that is likely correlated with their job prospects.
Potential explanations:
Ambiguity aversion and familiarity bias. Informational advantage.

Question 5

Naive diversification

Answer 5

Many investors seem to use strategies as simple as allocating 1/n of their savings to each of the n available investment options, whatever those options are.

Question 6

How does the set of investment alternatives affect portfolio diversification?

Answer 6

Positive relation across all assets between the share of fund options available in each asset class and the share of contributions made to funds in that asset class.

Question 7

What kind of investment options are added to the menu over time?

Answer 7

Changes in the average number of options: The average number of active equity funds increased from 1.6 to 6.4. In comparison, the number of equity index funds and other funds increased only modestly.

Question 8

What is the effect on investment costs and performance?

Answer 8

Switching from index equity funds to actively-managed funds increases average expenses for and reduces performance ranking of equity funds within the plan.

Question 9

Excessive trading

Answer 9

Barber and Odean (2000):
Large discount brokerage data over 1991-1996 period. Individual who trade the most, perform the worst.

Overconfidence explanation: Overconfident investors believe that they have private signals strong enough (level and/or precision) to justify a trade, whereas in fact the information is too weak to warrant any action.

Question 10

The effect of online trading on performance:

Answer 10

1) Investors who switch to online trading perform well prior to going online, beating the market by more than 2%.
2)
After going online, they trade more actively, more speculatively, and less profitably - underperformance by more than 3% annually.
Explanation: Increasing overconfidence due to
- Self-attribution bias,
- Availability bias,
- Illusion of knowledge - online investors have access to vast quantities of data, but lack training and experience compared to professional money managers,
- Active involvement, such as in online trading, fosters the illusion of control.

Question 11

The buying decision: Attention effect

Answer 11

ndividuals face huge search problem when choosing stocks to buy but only a limited amount of attention that they can devote to investing.
Attention effect: Rather than searching systematically through the thousands of listed shares until they find a good “buy,” many investors choose from a set of stocks that has caught their attention.

Question 12

Attention drawing events:

Answer 12

Extreme past performance, whether good or bad. Stocks with abnormally high trading volume.
Stocks with news announcements.
Media coverage Engelberg and Parsons (2011).

Question 13

Does media coverage of individual stocks influence trading of retail investors?

Answer 13

Media effects among buys and sells:
- Local media coverage significantly influences both buying and selling decisions.
- The effect is stronger on the buying than on the selling side.
Buying:
- Investors can buy any stock,
- Severe limited attention restrictions.
Selling:
- Retail investors usually do not sell short → only sell stock they already own,
- Limited attention not (strongly) binding.

Question 14

The selling decision: disposition effect

Answer 14

Disposition effect (Shefrin and Statman 1985): Investors have a preference for selling stocks that have increased in value since bought (winners) relative to stocks that have decreased in value since bought (losers).

Question 15

Explanations of the disposition effect

Answer 15

1 Rational explanations:
Tax considerations point to selling losers, not winners.
Information on future performance not confirmed in data (Odean 1998).
Portfolio rebalancing: Investors are much more likely to fully sell a stock when it has performed well (Calvet et al. 2009).
2 Behavioral explanation:
Irrational belief in mean reversion.
Prospect theory and mental accounting (narrow framing).

Question 16

Reverse disposition effect:

Answer 16

Inflows following high, outflows following low returns.

Question 17

Return-chasing flows of mutual fund investors

Answer 17

Sirri and Tuffano (1998) report nonlinear performance-flow relationship:
For funds in the bottom 80th percentile, there is no pronounced penalty for extremely poor relative performance.
However, the performance-flow relationship is very strong for funds whose historic performances place them in the top 20th percentile in the prior year.

Question 18

Smart money hypothesis

Answer 18

Some mutual fund managers have skill - some investors can detect fund manager skill and direct their flows accordingly.

• Little empirical support for longer term return persistence in equity mutual funds.
• Some funds just happen to hold relatively larger positions in last year’s winning stock by chance (Carhart 1997).
• These mutual funds receive relatively large inflows.
• Such sentiment-driven dumb money flows may cause some stocks to be overvalued and funds to underperform in the longer run (Frazzini and Lamont 2008).

Question 19

What is the summary of investor disposition effect?

Answer 19

The disposition effect in stocks and the reverse-disposition effect in funds are exhibited by the same investors at the same time.
Hence, these differences in the sign of the disposition effect between stocks and funds are not purely driven by investor characteristics (preferences or skill).
Increasing the level of cognitive dissonance causes an increase in the size of both the disposition effect in stocks and the reverse-disposition effect in funds.
The level of (perceived) delegation in the investment decision is related to the level of the reverse disposition effect.
Challenge for purely preference-based explanations of disposition effect: It seems that it is not just realized gains or losses that matter but also who is perceived to be responsible.

Question 20

Incentive effects:

Answer 20

Incentives to take excessive risk when trailing, or to lock-in gains when leading the benchmark.
Incentives to misreport performance:
- Strategically choose time period of reported returns.
- Incubator fund games.
- Use benchmarks that are easier to beat (Sensoy, 2009).

Question 21

Cognitive dissonance

Answer 21

the discomfort that arises when a person recognizes that he or she makes choices and/or holds beliefs that are inconsistent with each other

Question 22

Disposition effect in trading data

Answer 22

Disposition effect: Investor 3.9% more likely to sell a stock if it is at a gain. Reverse-disposition effect: Investor 6.6% less likely to sell a fund if it is at a gain. Probability to sell an asset that is at a loss reflected in the constant.
Not driven by preferences only: Results hold within the subsample of investors who simultaneously hold stocks and funds.

Index funds – same institutional details as actively managed mutual funds, but their manager is a less credible target to blame for the poor performance of the fund.

Question 23

Are mutual funds selecting mismatched benchmarks?

Answer 23

Yes, Mutual funds frequently have significantly different factor loadings than their self-designated benchmarks.

Mutual funds frequently have different self-designated benchmarks than suggested by their Morningstar classification. (This analysis does not automatically imply suboptimal benchmark choice.)

Question 24

Does performance relative to a mismatched self-designated benchmark influence fund flows?

Answer 24

Beating the mismatched benchmark by 1 percentage point predicts (at least) a 1.71 percentage point increase in inflows in the following year.
Trailing a mismatched benchmark is not punished after controlling for corrected benchmark, which also matters for flows!

Flows react to corrected benchmarks:
Some (sophisticated) investors understand mismatch. Both punish and reward following under-/outperformance.
Flows react to mismatched benchmark:
Some (naive) investors rely on mismatched self-designated benchmark when making investment decisions.
Bounded rationality - limited mental capacity or time/info constraints. Frame dependence - decision based on how information is presented. Only reward outperformance, no punishment.

Question 25

Are mismatched benchmarks strategic?

Answer 25

Mismatched self-designated benchmarks are not random, i.e., they are not a result of changing fund style over time:
1 Value funds are more likely than growth funds to have mismatched benchmarks on value/growth factor.
2 Small-cap funds are more likely than large-cap funds to have mismatched benchmarks on size factors.
3 Funds with higher fees and/or more assets under management are more likely to have mismatched benchmarks:
- Flows improve fund profits through fees.
- The percentage changes in flows is a larger dollar amount for mutual funds
with more assets under management.
4 There are fund family effects in the pattern of mismatched benchmarks: Mismatched benchmarks are typical for some mutual fund companies.

Question 26

Summary of Sensoy (2009)

Answer 26

Around 31.2 % of the mutual funds specify a mismatched benchmark index in the fund prospectus.
Mutual fund flows react strongly to the performance relative to a mismatched benchmark.
Mismatched self-designated benchmarks reflect funds’ strategic incentives (small style, value style, expensive funds, and funds with a lot of assets under management are more likely to specify a mismatched benchmark).