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The smart money loves dumb funds, too

May 23, 2011, 1:00 PM UTC

Mutual funds are, for the most part, democracies. When fund managers do poorly, their electorate–investors–can punish them by voting with their feet. So why do funds with lousy records still amass hundreds of millions of dollars in assets? The typical explanation is that retail investors, the individuals and households derided in Wall Street circles as “dumb money,” simply don’t know any better.

But as it turns out, the so-called smart money isn’t much smarter when it comes to mutual funds. A new working paper by Stephan Jank, an economist at the University of Tubingen in Germany, finds that “financial corporations” like funds of funds and banks are just as likely as individuals to stash their money in struggling funds. His findings run counter the notion that ignorance is the reason why dud funds continue to exist. (see study below)

Jank looked at the records of all security depositors in Germany, then broke down the composition of the country’s mutual funds by investor type: financial corporations, pension funds and insurers, and individuals. He then looked at those investors’ “flow-performance sensitivity,” or the rate at which they reacted to the success or failure of different mutual funds. Jank’s objective was to find out whether investors make bad decisions because they are “unsophisticated” (dumb money) or “institutionally disadvantaged” by regulations.

His first conclusion was that financial institutions are much more inclined to invest in funds with successful records. Amongst institutional investors, top performing funds attract inflows that are 31% higher than the inflows into middling funds; retail investors only invest 3% more in the best funds. Insurance companies and pensions fall somewhere in the middle, largely because of the restrictions placed on them by national investment laws.

Know when to fold ‘em

For mutual fund investors, performance chasing–a practice “mostly associated with uneducated or irrational investors,” Jank writes–is actually a sign of cunning. He draws on the work of Jonathan Berk, formerly a professor at U.C. Berkeley, and Richard Green at Carnegie Mellon, which posits that it’s rational to seek out funds with strong long-term records. The funds only begin to struggle, the theory says, after large inflows hamper their performance. By that logic, it’s wise to pursue winners–which is something that financial corporations excel at.

But while professional investors might be better at seeking out successful funds, they don’t demonstrate a similar talent for leaving ones that have performed poorly. Jank divided the mutual funds into five levels of performance and found that the percentage of sophisticated investors in the second-best group of performers was only 2% higher than the percentage in the worst group. That’s about on par with the breakdown between retail investors.

“The test cannot detect any systematic difference in investor composition between the worst performing funds and those with average performance,” he writes. “Thus, we do not observe a ‘burnout,’ where sophisticated investors exit poorly performing funds first and only disadvantaged and unsophisticated investors stay behind.”

There is a large body of work that explores why investors don’t act in their own best interest — irrational behavior is often chalked up to information asymmetry, which is the unequal distribution of knowledge between parties. But Jank’s study reveals that something else may be driving mutual fund investors to stick with bad funds. Financial corporations may have better access to information than most retail investors, but they aren’t using that information to make good decisions.

So why are mutual fund investors, both “smart” and “dumb,” reluctant to punish bad managers? Jank says they may be holding on to the hope that a long period of failure will drive a change in investing strategy, a theory posited in a 2003 study, “How Investors Interpret Past Fund Returns.”

There could also be a behavioral explanation. A 2000 paper, “The Behavior of Mutual Fund Investors,” notes that investors are twice as likely to sell a winning mutual fund than they are to sell a losing one. Nearly 40% of fund sales, it says, take place in funds that are ranked in the top fifth of all mutual funds.

That study looked at household investors, but it could just as easily be applied to financial corporations. Even giant funds and banks, after all, are helmed by individuals, who are hardly impervious to bad behavior. Investors may be sticking with terrible funds because of the “disposition effect,” which is the idea that people are naturally averse to taking losses.

It’s the same logic that drives gamblers to keep betting after they’ve already lost: No one likes to cash in their chips when they’re down.

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