Does Herding Behavior Reveal Skill? An Analysis of Mutual Fund Performance

Abstract

We uncover a negative relation between herding behavior and skill in the mutual fund industry.Our new, dynamic measure of fund-level herding captures the tendency of fund managers to follow the trades of the institutional crowd. We …nd that herding funds underperform their antiherding peers by over 2% per year. Di¤erences in skill drive this performance gap: antiherding funds make superior investment decisions even on stocks not heavily traded by institutions, and can anticipate the trades of the crowd; furthermore, the herding-antiherding performance gap is persistent, wider when skill is more valuable, and larger among managers with stronger career concerns.Keywords: Herding, mutual funds, performance, ability, imitation, alpha.J.E.L. codes: G11, G20, G23.Hao Jiang is at Michigan State University. Michela Verardo is at the London School of Economics. Corresponding author: Michela Verardo (m.verardo@lse.ac.uk). We thank two anonymous referees, an anonymous Associate Editor, and the Editor, Kenneth Singleton, for many insightful comments and suggestions. We are grateful for comments from Amil Dasgupta, Dong Lou, Christopher Polk, × ukasz Pomorski, René Stulz, Sheridan Titman, Dimitri Vayanos, Paul Woolley, and Kathy Yuan, as well as from conference participants at the 2011 IDC Summer Conference, 2012 WFA, and 2015 CFA UK Society and seminar participants at the Universities of Aarhus, Amsterdam, Arizona, BI Oslo, Cattolica Milan, Cologne, Drexel, Erasmus Rotterdam, ESSEC, IESE Barcelona, Kent, London School of Economics, Lugano, Mannheim, Michigan State, Nottingham, Reading, and Vienna. Verardo gratefully acknowledges …nancial support from the Paul Woolley Centre at the London School of Economics. The authors have no con ‡icts of interest to disclose.Theories of herding behavior predict that people tend to "follow the crowd"for a variety of reasons, for instance, to appear as talented as others or to learn from others. 1 One important yet underexplored feature of these models is the idea that less skilled individuals may herd on the decisions of their predecessors, while those with superior ability may be more likely to deviate from past actions-to the point of exhibiting antiherding behavior. Despite the rich implications of this intuition, however, there is little empirical evidence on the relationship between skill and the tendency to follow the crowd.In this paper we investigate the link between herding behavior and skill in the context of the mutual fund industry, which is an ideal setting to study the relation between herding and skill for two reasons. First, ample evidence shows that mutual funds and other institutional investors tend to herd in their buying and selling decisions. 2 Second, an extensive empirical literature on mutual fund performance analyzes the returns and investment decisions of mutual fund managers in an attempt to measure unobservable skill. 3 To address the question of whether investors can identify skilled and unskilled mutual fund managers by observing their tendency t...

Trading efficiency of fund families: Impact on fund performance and investment behavior

“…A similar comparison suggests that funds from the most efficient families hold cash positions that are one quarter smaller and also hold stocks that are significantly less liquid. These findings are consistent with theoretical arguments that trading 7 See, e.g., Carhart (1997), Barras, Scaillet, and Wermers (2010), Kacperczyk and Seru (2012) and Jiang and Verardo (2013). 5 costs influence the investment decisions of investors (see, e.g., Demsetz (1968)) such that investors reduce the amount of trading (Constantinides (1986)) and hold more liquid securities (Amihud and Mendelson (1986)) when facing higher trading costs.…”

“…For our final validity test we exploit the negative impact of turnover on fund performance, which is well documented in the literature (see, e.g., Carhart (1997), Barras, Scaillet, and Wermers (2010), Kacperczyk and Seru (2012) and Jiang and Verardo (2013)). Arguably, the negative performance effect of turnover is due to the fact that portfolio turnover causes trading costs, which hurt performance.…”

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