Investor behaviour in manager selection: impact on performance

Raul Leote de Carvalho

is deputy head of the Quant Research Group at
BNP Paribas Asset Management in Paris, France.
raul.leotedecarvalho@bnpparibas.com, Tel. +33 (0)1 58 97 21 83

6 February 2019

Keywords: active fund management, manager selection, dumb money, smart money, alpha chasing,
persistent flow

JEL Codes: G11, G14, G41

Executive summary

Selecting managers on the basis of past performance is an intuitive strategy that seems trusted by
investors. Indeed, many studies report a positive correlation between past fund returns and investor
cash flows. Evidence also suggests that at least at shorter-term horizons investing with the top
performing managers may generate future out-performance. This was initially dubbed the “smart
money” effect, the idea that investors are capable of identifying manager skill. More recent studies
suggest that manager exposure to momentum stocks, on one hand, and the persistency of fund flows,
on the other hand, are the more likely explanations of the fact that past and future fund alphas seem to
be positively correlated at shorter-term horizons in the pooled cross-section of funds. However, at
longer-term horizons, e.g. over the standard investment evaluation horizon which is roughly three
years for the average institutional investors, there is evidence of a negative correlation between past
and future fund alpha. Managers with stronger performances seem more likely to underperform
subsequently over longer-term horizons. If there is mean reversion over the horizon of interest, then
the modern hiring/firing practice should lead to worse outcomes than the apparently paradoxical
strategy of investing in managers with poor performances and firing the successful ones. While such a
contrarian approach to manager selection might seem counter intuitive and unreasonable, there is at
least, a justification to it under this “dumb money” effect. A more practical approach consists on using
other factors than performance for manager selection. Literature supports the use of factors such as the
theoretical soundness of the “investment thesis” driving the fund’s strategy, the link between manager
compensation and fund performance or the fund active share.

“Return chasing” behaviour

Many studies document positive correlations between past performance and investor cash flows.
Warther (1995), Gruber (1996), Chevalier and Ellison (1997), Sirri and Tufano (1998), Zheng (1999),
Wermers (2003), Sapp and Tiwari (2004) and Frazzini and Lamont (2008) all report that fund flows

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are positively correlated with past performance. Lynch and Musto (2003) found that the sensitivity of
fund flows to positive past returns is always greater than the sensitivity to negative past returns. Thus,
the overall correlation between flows and returns is primarily due to positive cash flows chasing
positive returns, or “return-chasing” behaviour, as is often mentioned in literature. Bailey et al. (2011)
and others called this “buy high, sell low” investor mentality a biased behaviour.

Selecting managers based on their past outperformance does seem perfectly reasonable. Past
outperformance should be due to either luck or skill. If it is due to luck, then hiring or firing on the
basis of past performance should have no impact on average future returns. If it is due to skill, then
moving funds to more successful managers should increase the probability of future outperformance.
Therefore, relying on past fund manager performance should not be harmful, and may even prove
beneficial. Moreover, it is not difficult to see why for investment consultants and advisors, hiring fund
managers with great recent performances and firing fund managers with poor recent performances is
preferred: the opposite would be counterintuitive and therefore unacceptable to most investors.

Keeping it simple and intuitive is important. The performance measure most often employed in fund
manager selection is the simple return over the fund stated benchmark without any risk adjustment.
This is because the average investor does not tend to understand what is meant by risk adjustment,
much less why adjusting for risk would be appropriate.

Despite all of the above, according to Friesen and Nguyen (2018), investor “return chasing” behaviour
for US mutual funds has been declining over time. By 2011, “return chasing” behaviour had almost
vanished. But the same is not true for “alpha chasing” behaviour.

“Alpha chasing” behaviour

“Alpha chasing” behaviour relies on past performance measured using alphas from various factor
models, with CAPM being the most commonly used. Similar to the “return chasing” behaviour,
existing literature also documents a positive correlation between past alphas and mutual fund flows.
However, in contrast to “return chasing” behaviour, the “return chasing” behaviour is typically
interpreted as a sophisticated, or at least rational, investment strategy.

Friesen and Nguyen (2018) highlighted that “alpha chasing” behaviour has also been strong in the past
but, unlike “return chasing” behaviour, remains strong until today. Along with the increase in relative
importance for investors of fund alpha versus fund return, they also detected an increase in investor
sensitivity to past fund risk and to fund expenses since 2011.

Impact of investor behaviour on performance

Evidence that performance of funds may be predictable exists. For example, Elton, Gruber and Blake
(2011) reported a positive correlation between past and future alphas in the pooled cross-section.
2

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Hoberg, Kumar and Prabhala (2018) supported their results showing again evidence in the pooled
cross-section of mutual funds. The “smart money” effect, the “persistent-flow” hypothesis and the
“momentum” effect are all consistent with this evidence and suggest that investors should be able to
earn higher profits from investing with top performing managers based on past performance. However,
there is also evidence of a “dumb money” effect based on the observation that at fund level past alphas
are strongly and negatively correlated with future alphas. This apparent paradox seems to be resolved
by considering different investment horizons. The “dumb money” effect seems to dominate at the
longer investment horizons that are typically used for assessment of managers’ performance.

The “smart money” effect

The “smart money” effect contends that some individual investors can identify skilled fund managers
and benefit by placing their money with them. The effect was first proposed by Gruber (1996) and
Zheng (1999) when documenting a positive relation between mutual fund flows and the shorter-term
future fund performance. Later, Keswani and Stolin (2008) re-examined the issue and suggested that
the “smart money” effect seems present in the 1991 to 2004 period but not in the 1970 to 1990 period.
More importantly, Frazzini and Lamont (2008) found that out-performance is confined to short
horizons of about one quarter. At longer horizons he finds that another effect dominates, the “dumb
money effect”, which is explained below.

There are two strands of literature that challenge the idea that this positive relation between mutual
fund flows and the shorter-term future fund performance is a reflection of investor genuine skill in
manager selection, i.e. a “smart money” effect. The first claims that mutual funds tend to be exposed
to systematic factors such as momentum and that it is this exposure that explains the predictability of
fund returns. The second suggests that it is the persistency in fund flows that is responsible for the
subsequent short-term fund out-performance. This second explanation also suggests that at longer-
term horizons manager performance should actually mean revert when the flows reverse-out to chase
the next winner fund. Consequently, the persistency in fund flows is also consistent with the “dumb
money” effect at longer horizons proposed by Frazzini and Lamont (2008).

The “momentum” effect

Jegadeesh and Titman (1993) found that individual stock returns are characterized by a positive
momentum effect at horizons of 12 months followed by long-term reversals at horizons of 3 years.
Grinblatt, Titman, and Wermers (1995) found that the majority of mutual funds tend to actively invest
in positive-momentum stocks. Sapp and Tiwari (2004) suggested that exposure to systematic factors
such as momentum in equity mutual funds could indeed explain the positive relation between mutual
fund flows and the shorter-term future fund performance. Later, Sapp and Tiwari (2006) showed that
mutual fund risk-adjusted returns are predictable based on fund sensitivity to stock return momentum.

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Sapp (2011) examined and compared the profitability of three momentum-based trading strategies for
mutual funds. He showed that monthly rebalanced selection of funds based on prior 6-month return,
momentum factor loading or 1-year high NAV, all would have earned significant positive excess
returns in the period prior to his study. But he also showed that the performance of such strategies no
longer holds after controlling for stock return momentum.

The “persistent-flow” hypothesis

An alternative explanation for positive relation between mutual fund flows and the shorter-term future
fund performance is the “persistent flow” hypothesis. For instance, Wermers (2003) finds that investor
flow-related buying pushes up stock prices beyond the effect of stock return momentum and he
proposes that fund performance owes more to flow-related trades than to managers’ skill. Similarly,
Lou (2012) argues that because fund flows are highly persistent, mutual funds with past inflows
(outflows) are expected to receive additional capital (redemptions), expand (liquidate) their existing
holdings, and drive up (down) their own performance in subsequent periods. Unlike the “smart-money”
effect, which attributes the positive relation between fund flow and future fund performance to
investors’ ability to identify skilled fund managers, the persistent-flow hypothesis suggests a simple
mechanism of price pressure - investors’ flows to mutual funds drive this positive relation. Jiang and
Yuksel (2016) go further and find a stronger positive relation for the retail class than for the
institutional class. They also show that the more significant relationship for the retail class is mainly
driven by funds with net outflows, evidence inconsistent with the “smart-money” hypothesis. Finally,
they also find that retail funds exhibit greater persistence than institutional funds in net outflow. Once
they control for expected fund flows, the flow-performance relation is no longer significant. They
perform robustness checks based on international funds and bond funds and propose that their findings
are supportive of the “persistent-flow” explanation.

It is worth noting that Woolley and Vayanos (2012) proposed that performance-chasing flows should
not only create a positive short-term momentum effect in the performance of winner funds, the
“persistent-flow” effect, but also a reversal effect, dubbed the “dumb money” effect, when the flows
reverse-out to chase the next winner fund a few quarters ahead.

The “dumb money” effect

Indeed, despite the shorter-term performance effects, the alpha of individual funds tends to negatively
auto-correlated with past alpha. This negative correlation of past and future fund alphas explains what
is known as the “dumb money” effect, reflecting the fact that managers with the stronger past
performances seem more likely to underperform subsequently over the standard investment evaluation
horizons, which is roughly three years for the average institutional investors. Intuitively, if there is
mean reversion over the horizon of interest, then the modern hiring/firing practice should lead to

Electronic copy available at: https://ssrn.com/abstract=3697929

worse outcomes than the apparently paradoxical strategy of investing in managers with poor
performances and firing the successful ones. While such a contrarian approach to manager selection
might seem counter intuitive and unreasonable, there is at least, a justification to it under the “dumb
money” effect.

Frazzini and Lamont (2008) documented that the economic impact of the “dumb money” effect
dominates that from shorter-term fund performances. Evidence shows that the negative time-series
correlation at the fund level more than offsets any positive cross-sectional correlation across funds.

Frazzini and Lamont (2008) also documented that the economic impact of “dumb money” chasing past
returns that are negatively correlated with future returns using data through 2003, when investor
return-chasing was at its height. They concluded (pp. 316-17) that “fund flows appear to account for a
large fraction of this poor performance. Thus, the damage done by actively managed funds comes less
from fees and expenses, and more from the wealth-destroying reallocation across funds.” Investor
return-chasing behaviour did have a detrimental impact on investor returns. Friesen and Nguyen
(2018) highlighted that the switch of investor behaviour from return-chasing to alpha-chasing in recent
years was actually even more detrimental to performance than their previous focus on past returns.

Finally, Cornell, Hsu and Nanigian (2016) confirmed that for portfolios evaluated and held over the
three-year periods, the performance of investors who chose funds with poor recent performance was
higher than the performance of investors who chose funds with great recent performance. The superior
return to investing in “loser funds” over “winner funds” is statistically and economically large, and is
robust to variation in the evaluation and holding periods as well as to standard risk adjustments. They
proposed that investors should consider factors other than performance to select managers. Among
those factors they cite the theoretical soundness of the “investment thesis” that drives a fund’s
portfolio management strategy (Cornell (2011)), performance-linked bonuses in fund manager
compensation packages (Ma, Tang, and Gómez (2015)), a high active share (Cremers and Petajisto
(2009), Amihud and Goyenko (2013)), the presence of a short-term redemption fee (Finke, Nanigian,
and Waller (2015)), having PhDs in key portfolio roles (Chaudhuri, Ivkovich, Pollet, and Trzcinka
(2013)), having a strong positive firm culture (Heisinger, Hsu, and Ware (2015)), outsourced
execution of shareholder services (Sorhage (2015)), a high level of fund manager ownership (Khorana,
Servaes, and Wedge (2007)), board of director ownership (Cremers, Driessen, Maenhout, and
Weinbaum (2009)) and lack of affiliation with an investment bank (Hao and Yan (2012)).

Conclusion

There is strong evidence that fund performance in terms of past returns or past alpha is the key factor
for manager selection. Investor cash flows are positively correlated with past alpha and returns. Fund
returns have been diminishing in importance for manager selection but past alpha remains a key driver.

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Past research suggests that in the short-term a strategy based on investing in the winner funds with
strongest past performances can generate positive returns. However, the evidence shows that winner
funds only out-perform in the pooled cross-section in the shorter term, typically over the next quarter.
This short-term effect is likely due to the systematic exposures of funds to momentum factors and to
the persistency of investor cash flows into winner funds. Conversely, at the longer investment horizons
typically used by institutional investors, e.g. three years, there is evidence of a negative correlation
between past and future fund alpha. With such longer investment horizons, a strategy based on past
performance to identify winner funds is harmful for future performance. For this reason, the “return-
chasing” and “alpha-chasing” investor behaviour chasing winner funds for longer horizons is known
as the “dumb money” effect. Cash flows of investors moving from a fund to the next winner fund can
explain this longer horizon reversal in fund performance. Investors are thus advised to consider other
factors than performance, e.g. theoretical soundness of the “investment thesis”, when selecting funds
at such horizons.

Disclaimer

The views and opinions expressed herein are those of the authors and do not necessarily reflect the
views of BNP Paribas Asset Management, its affiliates or employees.

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