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Title: Essays on mutual fund underperformance
Author: Jin, Liang
ISNI:       0000 0004 5924 2231
Awarding Body: University of Warwick
Current Institution: University of Warwick
Date of Award: 2015
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This thesis consists of three essays that study mutual fund manager abilities and investment performance. Extant research suggests that mutual fund managers, as a representative group of professional investors, fail to outperform passive benchmarks. My thesis explores potential sources of fund manager underperformance. Specifically, it investigates whether fund managers have "bad" skills that persistently affect fund performance and, in addition, sheds new light on mutual fund underperformance by investigating the prevalence of behavioural biases among fund managers. My first empirical study examines whether mutual fund managers possess distinct trading skills. By decomposing aggregate characteristic-timing performance into buying and selling components, I show that on average mutual fund managers exhibit positive characteristic-timing ability when buying stocks but negative characteristic-timing ability when selling stocks. Further persistence tests demonstrate that these differential trading skills are not merely due to chance: fund managers who exhibit superior characteristic-timing performance when buying stocks continue performing buying tasks well, while those who were poor performers in selling tend to underperform in the selling domain in the future. These results suggest that the lack of evidence of timing ability in the literature masks the distinct trading abilities that fund managers really possess. Moreover, using changes in portfolio style along size, book-to-market, and momentum dimensions (i.e., active style drift) as a proxy for strength of conviction, my analysis reveals an inverted U-shaped relationship between fund manager conviction and subsequent characteristic-timing performance. In particular, when fund managers engage aggressively in active style drift, their poor selling ability is overwhelming, leading to negative aggregate performance. My second study advances my investigation of fund performance and trading skills by considering the fact that fund managers are often forced to trade in response to investor flows. I find strong support for the hypothesis that the liquidity provision imposes significant indirect trading costs on mutual funds. Fund managers exhibit negative characteristic-timing performance only when they experience significant fund inflows. By conditioning fund trades on the direction and magnitude of fund flows, my results are consistent with the theoretical predictions that liquidity-driven trades underperform valuation-motivated trades. In particular, fund managers making purely valuation-motivated purchases generate significant characteristic-timing performance but are not able to do so when compelled to work off excess cash from investor inflows. Fund managers are not able to produce characteristic-timing returns from their selling decisions, even when they are highly motivated by valuation beliefs. Further results reveal that fund managers who possess superior selling ability are also significantly better at buying stocks than the remaining funds and as a result, these fund managers exhibit significant higher aggregate characteristic-timing returns. Strikingly, fund managers who appear to buy stocks well are not able to outperform other funds when selling stocks and they exhibit no significant aggregate performance. Overall, these results highlight and reinforce the insight that fund managers have positive buying skill and negative selling skill. My final empirical study explores the effect of overconfidence on actively managed equity mutual fund managers. Using the sum of absolute deviations from the fund’s benchmark index (i.e., Active Share) as a proxy for confidence level, my results show that fund managers tend to boost their confidence after outstanding past performance: they are more likely to increase Active Share and also choose a much higher Active Share level. Such bias is more pronounced among solo-managed funds than team-managed funds. More importantly, I uncover an inverted U-shaped relationship between confidence level and subsequent performance. In particular, excessive overconfidence, as reflected in an extremely high level of Active Share, is associated with diminished future fund performance, as well as more extreme performance outcomes and greater performance dispersion. I further document irrational investor reaction to fund manager overconfidence. There is a marked bonus for good performance by overconfident managers, as rewarded by higher fund inflows, while there is no pronounced penalty for poor performance, compared to other funds with comparable performance. Investors are not averse to overconfident fund managers even if they lose them money!
Supervisor: Not available Sponsor: Not available
Qualification Name: Thesis (Ph.D.) Qualification Level: Doctoral
EThOS ID:  DOI: Not available
Keywords: HG Finance