Week 5 - Sensoy, B. A. (2009). Performance evaluation and self-designated benchmark indexes in the mutual fund industry

Question 1

What is the main idea of this paper?

Answer 1

• There is a strong positive relation between mutual fund flows and past relative performance
• SEC requires funds to tabulate a benchmark in the fund’s prospectus, however, they do not specify selection guidelines
• Exposure to common factors (like size and value) benefits funds, since they are able to beat their mismatched benchmark
• Question: are mutual funds selecting mismatched benchmarks? Does performance relative to the mismatched benchmark influence fund flows? Is this a strategic move?

Question 2

What are the main findings of this paper?

Answer 2

• Mutual funds frequently have mismatched self-designated benchmarks compared to their Morningstar classification
• 31.2% of the funds’ returns are more correlated with the corrected benchmarks’ returns compared to the actual benchmark
• Beating a mismatched benchmark (by 1%p) positively influences (1.7%) flows to mutual funds in the following year
• Trailing a mismatched benchmark is not punished after controlling for the corrected benchmark
• Some sophisticated investors understand a mismatched benchmark, and they both punish and reward following under/outperformance
• Naïve investors rely on mismatched benchmark due to bounded rationality (limited mental capacity, time/info constraints). They only reward outperformance, but do not punish underperformance
• The incremental flow from having a mismatched self-designated benchmark is equal to 14.6% of the average flow to funds with mismatched benchmark

Question 3

What are the conclusions?

Answer 3

• Around 31% of mutual funds have mismatched benchmarks in their prospectuses
• Flows to mutual funds react positively to overperformance of mismatched benchmark
• Mismatched benchmarks reflect fund strategies (value vs growth, small cap vs large cap, assets under management, etc)

Question 4

What is Bounded rationality concept?

Answer 4

• agents cannot make always rational decisions because they have to work under three constraints:
  Limited (sometimes even unreliable) information is available regarding possible alternatives and their consequences.
  Human mind has a limited capacity to evaluate the available information. Only a limited amount of time is available to make a decision.

Question 5

What is Frame dependance?

Answer 5

decisions made by agents depend on the way a problem is posed to them (discussed within prospect theory).

Question 6

What are the incentive effects?

Answer 6

• 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 7

What are the consequences of flows reacting to mismatched benchmarks

Answer 7

• 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.
  The incremental flow from having a mismatched self-designated benchmark is equal to 14.6% of the average flow to funds with mismatched benchmark.