Role of Reputation For Mutual Fund

Flows
Apoorva Javadekar1

September 2, 2015

Boston University, Department of

Broad Question
1. Question:
What causes investors to invest or withdraw money from
mutual funds?
)

In particular: what is the link between fund performance and

fund flows?

2. Litarature:
Narrow focus on Winner Chasing phenomenon
)

link between recent-most performance and fund flows ignoring

role for reputation of fund

3. This paper: Role of Fund Reputation

)
)

Investors choices
Risk Choices by fund managers

Why Study Fund Flows?

1. Important Vehicle of Investment
)
)

Large: Manage 15 Tr $ (ICI, 2014)

Dominant way to equities: (ICI -2014, French (2008))
)
)

HH through MF: owns 30% US equities

Direct holdings of HH: 20% of US equities

Participation: 46% of US HH invest

2. Understand Behavioral Patterns:

Investors learn about managerial ability through
= fund flows shed light on learning, information processing
returns
capacities etc.
)

3. Fund Flows Affect Managerial Risk Taking

)

)
)

Compensation flows: 90% MF managers paid as a % of

AUM
= flow patterns can affect risk taking
= impacts on asset prices

Literature Snapshot
1. Seminal Paper: Chevallier & Ellison (JPE,
1997)
Flows(t+1)

Returns(t)
= Convex Fund Flows in Recent Performance!
2. Why Interesting? Non-Linear Flows (could)
mean
Bad and extremely bad returns carry same
information !
)
Non-Bayesian Learning
)
Behavioral Biases
)

Motivating Role of Reputation

1. No Role For Reputation: Literature links time t returns (rit )
to time t + 1 fund flows (FF i ,t +1 )
2. Why a Problem? The way investor perceives current
performance depends upon historic performance
Why? History of Returns reputation
Manager 1: {rt3, rt2, rt1, rt} = {G, G, G, B }
Manager 2: {rt3, rt2, rt1, rt} = {B, B, B, B }
3. What it means for estimation?
FFi,t+1 = g (rit, ri,t1, ...) + errori,t+1
where g(.) is non-separable in returns
4. Useful For Studying Investors Learning
FF i,t+1 = g ( r , r
it
i,t1, ri,t2, ...)x
s x

= de c isio n

s x

= s ig n

=p r io

Data
1. Source: CRSP Survivor-Bias free mutual fund dataset
2. Time Period: 1980-2012.
3. Include:
)
)

Domestic, Open ended, equity funds

Growth, Income, Growth&Income, Small and Mid-Cap, Capital
Appreciation funds (Pastor, Stambaugh (2002))

4. Exclude
)
)
)
)

Sectoral, global and index or annuity funds

Funds with sales restrictions
young funds with less than 5 years
small funds (Assets < 10 Mn $)

5. Annual Frequency: Disclosures of yearly returns, ratings are

based on annual performance

Performance Measures
1. Reputation: Aggregate performance of 3 or 5 years prior to
current period
2. How to Measure Performance?
Factor Adjusted: CAPM or 3-factor (Fama,French
(2010), Kosowski (2006))
Peer Ranking (Within each investment style):
(Chevallier,Ellison (1997), Spiegel (2012))
)

3. Which Measure?
Not easy for naive investor to exploit factors like value,
premium or momentum = factor-mimicking is valued
(Berk, Binsbergen (2013))
Flows more sensitive to raw returns (Clifford (2011))
)
Peer ranking within each style control for bulk of risk
differentials across funds
CAPM wins the horse race amongst factor models
(Barber
et.al 2014)
)

4.I use both the measures: CAPM and Peer Ranking but not

Main Variables

1. Fund Flows: Main dependent variable is % growth in Assets

due to fund flows
FF i,t+1 =

A i,t+1 (A it (1 + r i,t+1 ))

A i t : Assets with fund i at time t

rit : Fund returns for period ended
t

A it

Empirical Methodology
1. Interact Reputation With Recent Performance: To
understand how investors mix signals with priors
K

= 0 +

FF i ,t +1

k=1

i ,t 1

(rankit )

Zk
+

i ,t 1

k=1

(rankit ) 2 + controls + i,t+1

2. Variables:
)
)

k Z k

Zik,t 1 : Dummy for reputation category (k ) at t 1

rankit [0,

1]

3. Structure:
)
Capture learning technology
No independent effects of reputation(t-1) on
flows(t+1):
)

Reputation affect flows only through posteriors

Results 1: OLS Estimation

Table:Reputation And Fund Flows
Only Short Term

Reputation

Dep Var:FFit+1

Peer

CAPM

Peer

CAPM

Time Effects
Standard Errors
N
Adj R-sq

Yes
Fund Clustered
13512
0.137

Yes
Fund Clustered
13512
0.135

Yes
Fund Clustered
11468
0.158

Yes
Fund Clustered
11468
0.148

Constant

-0.088***
0.109***
(0.021)
(0.021)
0.216***
0.202***
(0.010)
(0.010)
-0.894***
0.808***
(0.183)
(0.178)
-0.031***
(0.005)

-0.027***
(0.005)

-0.098***
0.126***
(0.022)
(0.022)
0.207***
0.193***
(0.011)
(0.011)
-0.830***
0.761***
(0.193)
(0.188)
-0.010
(0.005)

-0.006
(0.005)

-0.002

-0.002

-0.011***

-0.008***

Rank(t+1)

Risk(t)

Log Age (t)

Log Size(t)

FFit +1

Peer

CAPM

Peer

CAPM

Unconditional Estimates
Rank(t)

0.043

(0.041)

Rank-Sq(t)

0.296***

(0.043)

0.117**

(0.041)

0.223***

(0.043)

Low Reputation (Bottom 20%)

Top Reputation (Top 20%)

Rank(t)
Rank(t)

0.308***
-0.031
(0.059)
(0.054)

0.285***
-0.031
(0.061)
(0.060)

Rank-Sq(t)
Rank-Sq(t)

0.116
0.210***
-0.0693
(0.062)

0.124
0.250***
-0.0741
(0.074)

Mean Estimates Graph

Flow Sensitivities In Response to Reputation
Med reputation (t-1)

Top Reputation(t-1)

.2
0
-.2

Flow Growth(%)

.4

Low reputation (t-1)

.
5

.5

Rank (t)

95% Confidence Interval

.
5

Mean Flow Growth%(t+1)

Unconditional Estimates

.2
.1
0
-.1

Flow growth (t+1) %

.3

Short Term Performance And Flow Growth

.2

.4

Rank(t)

95 % Confidence Interval
Growth % (t+1)

.6

.8

1
Flow

Mean Estimates Graph

Flow Sensitivities In Response to Reputation
Med reputation (t-1)

Top Reputation(t-1)

.2
0
-.2

Flow Growth(%)

.4

Low reputation (t-1)

.
5

.5

Rank (t)

95% Confidence Interval

.
5

Mean Flow Growth%(t+1)

Piecewise Linear Specification

Reputation And Fund Flows (Piecewise Linear)
Medium Reputation

Top Reputation

-.2

.2

.4

Low Reputation

.
5

.5

.
5

Rank ( t)
95 % CI
Growth %

Flow

Implications
1. Shape:
)
)

Convex Fund Flows For Low Reputation

Linear Flows for Top Reputation

2. Level:
)

Flows% increasing in reputation for a given short-term rank

Break Even Rank: 0.90 for Low reputation funds Vs 0.40 for
Top repute funds

3. Slope:
)

Flow sensitivity is lower for low reputation, even at the extreme

high end of current performance.

Robustness Checks

1. Reputation: 3 or 5 or 7 years of history

2. Performance Measure: CAPM or Peer Ranks
3. Standard Errors:
)

Clustered SE (cluster by fund) with time effects controlled

using time dummies
Cluster by fund-year (Veldkamp et.al (2014))

4. Institutional Vs Individual Investors

5. Fixed Effects Model: To control for fund family effects

Robustness With Fixed Effects

Only Short Term

Dep Var:FFit+1
Rank(t)

Peer

CAPM

Reputation

Peer

CAPM

Unconditional Estimates
0.0345
0.0871*
(0.0435)
(0.0430)

Rank-Sq(t)

0.276***
0.232***
(0.0453)
(0.0448)

Low Reputation

Rank(t)

-0.0978

-0.140*

(0.0592)

(0.0630)

Section II:
Risk Shifting

Evidence on Risk Shifting: Background

1. Do mid-year losing funds change portfolio risk?
Convex flows = limited downside in payoff

2. Previous Papers:
)

Brown, Harlow, Starks (1996): Mid-Year losing funds

increase the portfolio volatility
Chevallier, Ellison (1997): marginal mid-year winners
benchmark but marginal losers
Busse (2001):
)
)

Uses daily data = efficient estimates of

No support for (r i t )

Basak(2007):
)

What is risk? or deviation from

benchmark/peers?
Shows that mid-year losers deviate from
benchmark
Portfolio risk can be up or down ( or )

Measuring Risk Shifting

1.Consider a simplest factor
model
R i t = i +

R tm +
s xs
i

lo a d ing

s x substantial (rit )
2. Fact: Factors (e.g market) explain
= p r ic e

3. (rit ) Flawed meaure: Lot of exogenous variation for

manager
4. Factor Loadings (): Within manager control = good
measure of risk-shifting
5. Measure of Devitation:
Risk = |

i,2t
for
s2nd half

2t
sx
median for 2nd half

Median for funds with same investment

style
)

Some Statistics
Table:Summary Statistics For Risk Change

Reputation Category
Variables

Low

Med

Top

1.04
1.03
0.19

1.02
1.00
0.15

1.02
1.00
0.20

0.12
0.084
0.14

0.09
0.066
0.09

0.12
0.091
0.11

Annual Beta
Mean
Median
Dispersion
Risk
Mean
Median
Dispersion

First Pass: Polynomial Smooth

Regression Results
Table:Risk Shifting
Unconditional

Control For Reputation

Dep: Beta Devitation

Peer

CAPM

Peer

CAPM

Time Effects
Style Effects
Standard Errors

Yes
Yes
Fund Clustered

Yes
Yes
Fund Clustered

Yes
Yes
Fund Clustered

Yes
Yes
Fund Clustered

Constant

0.298*
**
(0.015)
0.542*
**
(0.008)
-0.007
(0.004)

0.291*
**
(0.015)
0.543*
**
(0.008)
-0.007
(0.004)

0.304*
**
(0.015)
0.534*
**
(0.008)
-0.006
(0.004)

0.305*
**
(0.016)
0.532*
**
(0.008)
-0.006
(0.004)

-0.000
(0.001)

-0.000
(0.001)

-0.000
(0.001)

-0.002
(0.001)

Risk Rank (H1)

Log Age(t)

Log Size(t)

Unconditional Beta Deviation

Perf. Rank(H1)

-0.243***
(0.029)

-0.228***
(0.029)

Result Continued
Peer

CAPM
Peer

CAPM

Low Reputation(t)
Perf. Rank(H1)

-0.355***
(0.042)

-0.378***
(0.043)

Perf. Rank(H1)2

0.377***

0.410***

(0.048)
Medium Reputation(t)

(0.049)

Perf. Rank(H1)

-0.250***
(0.032)

-0.227***
(0.034)

Perf. Rank(H1)2

0.219***
(0.033)

0.208***
(0.034)

Top Reputation(t)
Perf. Rank(H1)

-0.0573

-0.0472

(0.042)

(0.043)

Mean Estimates For Risk-Shift

Discussion of Results

1. Low Reputation Funds

)

Severe career concerns

Low Mid-Year Rank: Gamble for resurrection

High Mid-Year Rank: Exploit convexity of flows as risk of

job-loss relatively low

2. Top Reputation Funds:

)

No immediate career concerns = Level of deviation slightly

higher
Flows Linear = No response to mid-year rank

Section III
Model Of Fund
Flows

Model Overview
1. Question: What explains the heterogeniety in observed
Fund-Flow schedules
2. Possible Answer:
)

Investor-Base is heterogenous for funds with different

reputation or track record.

3. Basic Intuition:
)
)

A model with loss-averse investors + partial visibility

Rational investors shift out of poor perfoming funds but
loss-averse agents stick

= Bad fund performs poor again: No outflows

= Poor fund perform Good: Some inflows as fund

becomes visible

Model Outline
1. Basic Set-Up:
)

Finite horizon model with T <

Two mutual funds indexed by i = 1, 2

Two types of investors (N of each type)

)
)

Rational Investors (R): 1 unit at t = 0

Loss-Averse Investors (B): has units at t = 0

2. At t = 0: Each fund has 2N of each type of

investors
3. Partial Visibility:
)
)

Fund is visible to fund insiders at year end

Fund visibility at t to outsiders increases with performance at
time t
visible = entire history is known

Returns and Beliefs

1. Return Dynamics:
ri,t+1 = i + it+1
.

it+1 N 0, ( ) 2

where i = unobserved ability of manager

i
.
.
2
i t N it , (t )
I i t = Set of investors to whom i is visible
Forinvestors
every j are
I i t ,Bayesian
priors at end
t arePosteriors with
All
= of
Normal
.
.
(t )

= + (r
)
2
it +1
it
it
i ,t +1
(t )2 + ()2

2. Beliefs:
)
)

Loss-Averse Investors
1. Assumptions:
)
)

Invest in only one of the visible funds at a time

Solves Two period problem every t as if model ends at t +

2. Preferences: Following Barberis, Xiong (2009)

)
)

t = accumulated loss/gain for investor of B type with i

Instantaneous Utility realized only upon liquidation
.

u (t ) = t 1 (t < 0) + t 1 (t 0) If sell
0
If no sell
)

Evolution of

t
t +1 =
rj ,t +1

t+1 + ri,t+1

If no sell
If shift to fund j I i
If exit from industry

3. Trade-off: = B can mark-to-market loss today and exit fund

0 in hope that rit+1 is large enough

i or carry forward losses
4. Why? Loss hurts more: > 1

Motivation For Loss-Averse Investors

1. Strong Empirical Support:
Shefrin, Statman (1985), Odean(1998): Investors hold on
to losses for long but realize gains early
)
Calvet,Cambell, Sodini(2009): Slightly weaker but robust
tendency to hold on losing mutual funds
Heath (1999): Disposition effect present in ESOPs
)
Brown (2006), Frazzini (2006): Institutional traders exhibit
tendency to hold losing investments
)

2. Why Realized Loss-Aversion?

)

Barberis, Xiong (2009): Realization Loss Averse preferences

can generate disposition effect
Usual Prospect utility preferences over terminal gain/loss need
not generate tendency to hold losses

Problem of Loss-Averse Investor

Keep Vs Sell Decision: B type invested in fund i =
.
.
,
,
1
V t , {it } i
= max Vtsell , Vt
, keep
=1,2 V
exit
t

Problem of Loss-Averse Investor

Keep Vs Sell Decision: B type invested in fund i =
.
.
,
,
1
V t , {it } i
= max Vtsell , Vt
, keep
=1,2 V
In turn
,)
r

E [u ( +

) | ]
1t

exit
t

Problem of Loss-Averse Investor

Keep Vs Sell Decision: B type invested in fund i =
.
.
,
,
1
= max Vtsell , Vt
, keep
V t , { it } i
V =1,2
In turn
exit

t
, ) = E [u ( +
) | ]
1t
r
= P (t + r1t+1 0) E t [t + r1t+1|t + r1t+1 0]

Problem of Loss-Averse Investor

Keep Vs Sell Decision: B type invested in fund i =
.
.
,
,
1
V t , {it } i
= max Vtsell , Vt
, keep
=1,2 V
In turn
exit

t
, ) = E [u ( +
) | ]
1t
r
= P (t + r1t+1 0) E t [t + r1t+1|t + r1t+1 0]

+ P (t + r1t+1 < 0) Et [t + r1t+1|t + r1t+1 < 0]

Problem of Loss-Averse Investor

Keep Vs Sell Decision: B type invested in fund i =
.
.
,
,
1
V t , {it } i
= max Vtsell , Vt
, keep
=1,2 V
In turn
exit

t
, ) = E [u ( +
) | ]
1t
= rP (t + r1t+1 0) E t [t + r1t+1|t + r1t+1 0]

+ P (t + r1t+1 < 0) Et [t + r1t+1|t + r1t+1 < 0]

Q ( + )
t

1t

Problem of Loss-Averse Investor

Keep Vs Sell Decision: B type invested in fund i =
.
.
,
,
1
V t , it } i
= max Vtsell , Vt
, keep
{
V =1,2
In turn

exit
t
, ) = E [u ( +
) | ]
1t
r
P (t + r1t+1 0) E t [t + r1t+1|t + r1t+1 0]
=
+ P (t + r1t+1 < 0) Et [t + r1t+1|t + r1t+1 < 0]
= Q ( + )
t

V sell ( , )
t 2t
(r

1t

u (t ) + E [u
t

) | ]

2t+1

2t

Problem of Loss-Averse Investor

Keep Vs Sell Decision: B type invested in fund i =
.
.
,
,
1
V t , {it } i
= max Vtsell , Vt
, keep
=1,2 V
In turn
,)
r

exit
t

) | ]
1t

P (t + r1t+1 0) E t [t + r1t+1|t + r1t+1 0]

+ P (t + r1t+1 < 0) Et [t + r1t+1|t + r1t+1 < 0]

Q ( + )

V sell ( , )
t 2t
(r

E [u ( +

1t

u (t ) + E [u
t

) | ]

2t+1

2t

Problem of Loss-Averse Investor

Keep Vs Sell Decision: B type invested in fund i =
.
.
,
,
1
V t , {it } i
= max Vtsell , Vt
, keep
=1,2 V
In turn
,)
r

exit
t

) | ]
1t

P (t + r1t+1 0) E t [t + r1t+1|t + r1t+1 0]

+ P (t + r1t+1 < 0) Et [t + r1t+1|t + r1t+1 < 0]

Q ( + )

V sell ( , )
t 2t
(r

E [u ( +

1t

u (t ) + E [u
t

) | ]

2t+1

2t

= u (t ) + P (r2t+1 0) E t [r2t+1|r2t+1 0]

Problem of Loss-Averse Investor

Keep Vs Sell Decision: B type invested in fund i =
.
.
,
,
1
V t , it } i
= max Vtsell , Vt
, keep
{
V =1,2
In turn

exit
t
, ) = E [u ( +
) | ]
1t
r
P (t + r1t+1 0) E t [t + r1t+1|t + r1t+1 0]
=
+ P (t + r1t+1 < 0) Et [t + r1t+1|t + r1t+1 < 0]
= Q ( + )
t

V sell ( , )
t 2t
(r

1t

u (t ) + E [u
t

) | ]

2t+1

2t

= u (t ) + P (r2t+1 0) E t [r2t+1|r2t+1 0]
+P (r2t+1 < 0) E t [r2t+1|r2t+1 < 0]

Problem of Loss-Averse Investor

Keep Vs Sell Decision: B type invested in fund i =
.
.
,
,
1
V t , {it } i
= max Vtsell , Vt
, keep
=1,2 V
In turn
,)
r

=
=
=

Vsell ( ,

t 2t

E [u ( +

) | ]
1t

exit
t

P (t + r1t+1 0) E t [t + r1t+1|t + r1t+1 0]

+ P (t + r1t+1 < 0) Et [t + r1t+1|t + r1t+1 < 0]
Q ( + )
t

1t

) = u (t ) + E [u
) | ]
t
2t+1 2t
(r
= u (t ) + P (r2t+1 0) E t [r2t+1|r2t+1 0]
+P (r2t+1 < 0) E t [r2t+1|r2t+1 < 0]
= u( )t + Q ( )
2t

Properties of Q()
1.Expression for Q(), R
.

Q () = + ( 1)

. .

Q ()in . In particular, one unit rise

2. Q() is increasing
.
.
= 1 + ( 1)
in
(1,
changes Q()by more
) than 1 unit
3. Q() is concave, with lim Q()
= 1

(
2Q ()
=
1)

. .

<

Optimal Policy For Loss Averse Investor

1. Result 1: Participation
Premium
)
)

For any t , liquidation of current fund is optimal if <

1t
0.
In fact, break-even skill is positive. That is if
Vkeep (1,min(t ), t ) = Vexit (t ), then 1,min(t ) > 0, for any
t
Similarly, break-even level for manager 2 skill 2,min > 0. Else
B will exit but not shift to fund 2

2. How to interpret LOW reputation then?

)

Relative: Low relative to Top, but still with positive expected

excess returns.
Replacement Theory: Bad managers are replaced or bad
funds merge with good funds. Hence expectation about fund
returns never go negative (e.g Lynch,Musto 2003)

3. Assumption: > 2,min and ( ) >

2t
1t t
2,min

(t )

Optimal Policy For Loss-Averse Investor

1. Result 2: Hold Losses Unless Fund is Extremely
Bad ) If Q ( ) < , then B holds if < ( , ), for
2t

1t

( , ) <
some
1t 2t
0

1t 2t

2. Understanding Why?
Q()

<=

s x

=Margi nal v alu e to

ut()
s
=Marginal
Lossx

skill

= realizing loss is costly if is small or t < 0 is large in

magnitude.

Note If shifted
Gain =

Q()

(2t 1t

) =
Loss
t

Optimal Policy
1. Result 3: Loss-Holding Region Increases in
1t
) Why? Relative gain from shifting (

) decreases as

2t

increases

1t

1t

2. Result 4: Policy For

Gains) If Q ( ) < , hold gains if greater than

)
)

2t

1t

2t

1t

( , ) >
some
1t 2t
0
If Q ( ) > , liquidate any gain.

Why? Hold large gains in some cases as current gains reduces

probability that t+1 = t + rit+1 < 0

3. Result 5: No Liquidation If Manager Is Better

)
)

No liquidation is optimal if

1t

>

2t

for any given t R

Why? If > , then sticking with same manager is

1t
2t
best chance to recover losses (given participation is
the
satisfied)

Illustration Of Optimal Policy

Figure:Hold Losses Even if 1 < 2

Illustration Of Optimal Policy

Figure:Loss-Holding Region

Optimal Policy For Rational Investor

1. Objective: Mean-Variance
Optimization
.
R
=
max
t t
Vt
HtR

2. Solution:

.
2 t

i = it2
it

3. Discussion:
)

Simplification: General time consistent policy under learning

is complicated
Lynch&Musto (2003): Similar simplification assumption
with exponential utility and one-period investors
Alternative: Assume exponential utility and one-period
agents, so that policy of old and new agent coincide given
information

Dynamics Of Investor-Base
Figure: Dynamics Of Investor-Base

Sequence of poor performce = Higher fraction of

Loss-Averse Investors in Fund

Equilibrium Fund Flows

Figure: Fund Flow

Schedules

Alternative Theories
1. Lynch & Musto (JF,2003):
)

)
)

Optimal replacement of manager by company below a cut-off

performance
= Magnitude of shortfall has no information content
= asset demand similar below cut-off

2. Berk & Green (JPE,2004)

Decreasing returns to scale
Quantities (size of fund) adjust so that expected excess returns
on all funds are equalized to zero
Return chasing, differential abilities and lack of persistence are
all consistent with each other
)
)

3. Lynch & Musto For Current Evidence?

)
)

P(firing) and hence convexity decreasing in reputation

Consistent with empirics? Some manager firing even for Top
category
= Some insensitivity should have been observed if firing
mechanism was true

Conclusions

1. Lack of Flow Convexity for Reputed Funds (or for 40% of

Industry money)
2.No Risk Shifting For Top funds in response to Mid-Year rank
3.Some 2

nd

half risk-sfiting for bad repute funds

4.Fund Flow heterogeniety could be explained through presence

of loss-averse investors

Thank You !