Can Mutual Fund Investors Distinguish Good from Bad Managers?

• Author: Teodor Dyakov,Marno Verbeek
• DOI: http://doi.org/10.1111/irfi.12187
• Published date: 01 September 2019
• Date: 01 September 2019

Can Mutual Fund Investors

Distinguish Good from Bad

Managers?*

TEODOR DYAKOV

†

AND MARNO VERBEEK

‡

†

School of Business and Economics, VU Amsterdam and Tinbergen Institute,

Amsterdam, The Netherlands and

‡

Rotterdam School of Management, Erasmus University Rotterdam, Rotterdam,

The Netherlands

ABSTRACT

Mutual fund flows respond significantly to the return gap, which captures

information about unobserved actions of mutual funds and predicts future

performance. The sensitivity of fund flows to the return gap is: (i) strong and

positive; (ii) increasing with investor sophistication; (iii) highly nonlinear;

and (iv) decreasing with the informativeness of past fund returns. On aver-

age, the response of investors to the return gap enhances their performance.

Our findings suggest there is a sophisticated mass of investors who can dis-

tinguish good from bad managers using information that may not be directly

inferred from standard performance indicators.

Accepted: 17 February 2018

I. INTRODUCTION

With currently more than $8.5 trillion in assets under management

1

, the equity

mutual fund industry holds a substantial amount of the total market portfolio

in the USA. Understanding how investors move capital across the plenitude of

funds available is therefore important for understanding the allocative effi-

ciency of capital markets. The extensive mutual fund literature has studied vari-

ous determinants of mutual fund flows, with the overall conclusion that

investors tend to make naive decisions. Most notably, past studies have shown

that investors make decisions largely based on past performance (e.g., Ippolito

1992; Chevalier and Ellison 1997; Sirri and Tufano 1998), even though past

* We would like to thank Dion Bongaerts, Mathijs Cosemans, Mathijs A. van Dijk, Egemen Genc,

Jiekun Huang, Hao Jiang, Clemens Sialm, Meijun Qian, Buhui Qiu, Darya Yuferova, and seminar

participants at the VU Amsterdam, National University of Singapore Business School, New Economic

School Moscow, the Rotterdam School of Management, Erasmus University, and the 2013 FMA

European Conference in Luxembourg, for helpful comments. Part of this project was undertaken

while Teodor Dyakov was a visiting scholar at the National University of Singapore. The financial

support of the Vereniging Trustfonds Erasmus Universiteit Rotterdam is gratefully acknowledged.

1 According to data from the Investment Company Institute for December 2016.

© 2018 The Authors. International Review of Finance published by John Wiley & Sons Australia, Ltd on

behalf of International Review of Finance Ltd (IRF)

This is an open access article under the terms of the Creative Commons Attribution-NonCommercial License,

which permits use, distribution and reproduction in any medium, provided the original work is properly cited

and is not used for commercial purposes.

International Review of Finance, 19:3, 2019: pp. 505–540

DOI: 10.1111/irfi.12187

performance appears to be a poor predictor of future performance (e.g., Carhart

1997). Recent results from the behavioral literature further point to the direc-

tion that investors often seem to be naive and inexperienced in their

decisions.

2

In this paper, we want to augment our knowledge on the drivers behind

mutual fund flows by investigating whether investors direct flows towards man-

agers likely to add value in the future. We argue that investors may possess

information about future performance which is not directly captured by observ-

able fund characteristics. Investors may base their inferences on information

coming from qualitative sources, an analysis of fund holdings, reading analysts’

reports, and so on. As long as the performance signal that investors derive is

not captured by observable fund characteristics, regressing fund flows on fund

characteristics might miss important insights about some of the drivers behind

fund flows.

We use the return gap of Kacperczyk et al. (2008) to proxy such information

about future performance. Kacperczyk et al. (2008) show that the return gap,

calculated as the difference between the reported fund returns and the hypo-

thetical return of the fund’s most recently disclosed holdings, is highly persis-

tent and predicts future performance. The return gap is particularly useful for

avoiding poorly performing funds in the future. In contrast to the return gap,

conventional performance measurements have very limited ability to distin-

guish good from bad fund mangers. Moreover, the return gap cannot be

explained by observable fund characteristics, such as past performance. These

results suggest the existence of information about future performance orthogo-

nal to previously studied observable fund characteristics as determinants of

mutual fund flows.

Accordingly, we investigate whether mutual fund flows are related to infor-

mation about future performance reflected in the return gap. A positive correla-

tion between fund flows and past realizations of the return gap would indicate

that mutual fund investors are able to differentiate good from bad managers

using information beyond readily available performance indicators. Such posi-

tive correlation does not require investors to be able to actually calculate the

return gap for each fund. Instead, it suggests that investors use information sig-

nals correlated with the information content of the return gap when investing

in funds.

Using a large panel of nearly 2500 actively managed US equity mutual funds

over the period 1990 to 2010, we find strong support for this conjecture. Our

results show a strong sensitivity of fund flows to the return gap, over and above

other performance indicators. More specifically, a one standard deviation

increase in the return gap during the last year is followed by a 0.74% increase

in money flows in the following quarter. This finding indicates that mutual

fund investors use information about future performance beyond standard

2 Examples include Barber et al. (2005), Cooper et al. (2005), Choi et al. (2010), Bailey

et al. (2011), and Frazzini and Lamont (2008).

© 2018 The Authors. International Review of Finance published by John Wiley & Sons Australia, Ltd on

behalf of International Review of Finance Ltd (IRF)

506

International Review of Finance

backward-looking performance measures, like returns and alphas, in their allo-

cation decisions.

Separating bad from good managers is a process that requires a certain

degree of investor sophistication. Consistent with this notion, we find that

the sensitivity of fund flows to the return gap is stronger for institutional

investors than for retail investors. Furthermore, we find that almost all of

the sensitivity of fund flowsisdrivenbyaresponsetofundsinthetop

return gap quintile. We also find that the sensitivity of fund flows to the

return gap is stronger when there is less cross-sectional dispersion in fund

performance, implying that the performance information investors obtain

becomesmoreimportantwhenthereislessinformationinpastnet

performance.

We further investigate the economic importance from our main finding

that fund flows respond to the return gap. Given that the return gap is

related to future performance, the positive sensitivity of fund flows to past

realizations of the return gap suggests that investors enhance their returns

from directing flows towards high return gap funds and avoiding low return

gap funds. To assess the economic magnitude of this effect, we first calculate

for each fund the difference between the expected fund flows from a flow-

performance model including the return gap with those from a flow-

performance model excluding the return gap. This difference captures the

differential capital allocated to mutual funds that is attributed to differences

in their return gaps. Next, we sort funds into 10 decile portfolios based on

this difference and investigate their performance over time. The four-factor

alphas of the spreads between the top and bottom portfolios amount

to 18 to 21 bp per month, depending on the specification. These effects

imply a sizable economic benefit that investors realize from directing flows

towards high return gap funds and particularly from avoiding low return gap

funds.

We next test whether invest ors are guided towards bette r fund managers

by brokers and financial advisers. Our resu lts do not offer evidence for t his

conjecture. We do not find significant differences in the sensitiv ity of fund

flows to the return gap across inv estors using financial advisers and brokers

and those who do not. For robust ness, we show that very littl e of the sensi-

tivity of fund flows to the return gap can be attribut ed to readily available

performance indicators and fund characteristics. This evidence supports our

conjecture that investo rs are able to infer informati on about future perfor-

mance which may not be direct ly observable or easily deduc ed from fund

characteristics.

An alternative explanation for our findings is related to momentum. A high

return gap may be the result of funds chasing high momentum stocks. Under

this conjecture, funds with high return gaps generate high returns because of

momentum. This is unlikely to be the case. First, we show that funds with high

return gaps outperform funds with low return gaps even after controlling for

exposure to the momentum risk factor. Second, past performance, together

© 2018 The Authors. International Review of Finance published by John Wiley & Sons Australia, Ltd on

behalf of International Review of Finance Ltd (IRF)

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Distinguishing Good from Bad Fund Managers