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Mutual Fund Investor Learning and the Economic Cost of Seeking Alpha

Last Updated on 10 February, 2024 by Rejaul Karim

In the intricate tapestry of mutual fund investing, Geoffrey C. Friesen and Viet Nguyen unravel the evolving dynamics in “Mutual Fund Investor Learning and the Economic Cost of Seeking Alpha.

Across the expanse of 79 pages, this study dissects the metamorphosis of equity mutual fund investor behavior from 1991 to 2016, unveiling a shift in attention from past returns to factors with potential future impact, such as risk, alpha, and expenses. The authors correlate these changes with shifts in linguistic emphasis within the media and academic discourse.

Delving deeper, the research scrutinizes the effect of heightened focus on fund alphas, revealing the nuanced interplay between fund selection and timing. As the study navigates through the intricacies, it elucidates that while investors grasp the significance of alpha, the challenge lies in effectively translating this awareness into judicious investment decisions.

The narrative unfolds, exposing the intricate dance between smart and dumb money, ultimately showcasing the multifaceted landscape of mutual fund investing and the enduring quest for alpha optimization.

Abstract Of Paper

This study analyzes how equity mutual fund investor behavior has changed over time, and the associated impact on investor returns. First, we find that from 1991-2016 investor return-chasing behavior declined and more recently disappeared, while investor flows have become more sensitive to expenses, past risk and alpha. We also present evidence that these changes correspond to changes in word usage and attention to alphas, past returns and fund expenses in the popular press and academic journals. Investors now pay more attention to fund characteristics that have the potential to improve future performance (e.g. risk, alpha and expenses), and less attention to characteristics that don’t (e.g. past returns). Second, we examine the effect of increased attention to fund alphas on investors’ realized performance. We confirm the well-documented positive persistence of alpha, but note that this positive cross-sectional persistence in alphas measures the net effect of two distinct phenomena: the cross-sectional variation in average alphas across funds (Harvey and Liu, 2018), and the time-series autocorrelation of alpha within each fund. Both properties are independently relevant: fund selection relates to investors’ ability to exploit variation in alphas across funds; timing relates to the ability to exploit the autocorrelation patterns within a given fund. We show that at the fund level, alphas have strong negative serial correlation. Lastly we decompose total mutual fund investor Performance Gap into fund selection and timing components, then further decompose each of these into pieces related to each individual determinant of the cashflow, so that we can determine how much each individual behavior contributes to both fund selection and timing. Even though investors realize some benefit from selecting high-alpha funds (smart money), they time their cash flows very poorly by investing in those funds after periods with the highest realized alphas (dumb money). The dumb money effect dominates, and we show that chasing alphas reduces investor returns by three times as much as chasing past returns. Overall, our results suggest that mutual fund investors have learned that alpha is important, but have not yet learned how to effectively integrate this knowledge into their investment decisions.

Original paper – Download PDF

Here you can download the PDF and original paper of Mutual Fund Investor Learning and the Economic Cost of Seeking Alpha.

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Author

Geoffrey C. Friesen
University of Nebraska at Lincoln – Department of Finance

Viet Nguyen
University of Nebraska at Lincoln – Department of Finance, Students

Conclusion

In summary, this study unveils a transformed landscape in equity mutual fund investor behavior, marked by a decline in return-chasing and a heightened focus on key performance indicators. The shift reflects an increased awareness of factors conducive to future performance, such as risk, alpha, and expenses.

However, despite recognizing the importance of alpha, investors grapple with effective integration into their decision-making, leading to suboptimal timing choices. The disappearance of return-chasing aligns with shifts in media attention, emphasizing the external influences on investor decisions.

The nuanced examination of increased attention to fund alphas reveals a complex reality, with positive alpha persistence tempered by strong negative serial correlation at the fund level. Ultimately, this study highlights the ongoing challenges mutual fund investors face in translating awareness into optimal investment decisions, impacting overall returns.

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FAQ

1. What is the main focus of the study by Geoffrey C. Friesen and Viet Nguyen, titled “Mutual Fund Investor Learning and the Economic Cost of Seeking Alpha”?

The study analyzes the evolution of equity mutual fund investor behavior from 1991 to 2016, with a particular emphasis on changes in attention to various performance indicators. The authors explore the impact of shifts in investor behavior on returns and correlate these changes with alterations in media and academic discourse.

2. What are the key findings regarding changes in investor behavior, and how do these changes correspond to shifts in media and academic attention?

The study reveals a decline in return-chasing behavior among mutual fund investors, replaced by a heightened focus on factors with potential future impact, such as risk, alpha, and expenses. These changes align with shifts in media and academic attention, indicating that investors now pay more attention to characteristics conducive to future performance.

3. How does the study evaluate the impact of increased attention to fund alphas on investors’ realized performance, and what are the key challenges faced by investors despite their awareness of the importance of alpha?

The study identifies a complex reality in the increased attention to fund alphas, showing positive alpha persistence but also strong negative serial correlation at the fund level. Despite recognizing the importance of alpha, investors struggle with effective integration into their decision-making, resulting in suboptimal timing choices. The study suggests that while investors have learned that alpha is important, challenges persist in translating this knowledge into optimal investment decisions.

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