How Investors Interpret Past Fund Returns

Abstract

The literature documents a convex relation between past returns and fund flows of mutual funds. We show this to be consistent with fund incentives, because funds discard exactly those strategies which underperform. Past returns tell less about the future performance of funds which discard, so flows are less sensitive to them when they are poor. Our model predicts that strategy changes only occur after bad performance, and that bad performers who change strategy have dollar flow and future performance that are less sensitive to current performance than those that do not. Empirical tests support both predictions. Disciplines Finance | Finance and Financial ManagementThis journal article is available at ScholarlyCommons: http://repository.upenn.edu/fnce_papers/276 How Investors Interpret Past Fund ReturnsAnthony W. Lynch and David K. Musto * * Lynch is from New York University and NBER and Musto is from University of Pennsylvania. We are grateful for comments from Franklin Allen, Stephen Brown, Jennifer Carpenter, Doug Diamond, Ned Elton, Will Goetzmann, Gary Gorton, Bruce Grundy, Rudi Schadt, René Stulz, S. Viswanathan and participants in the Corporate Finance and Friday lunchtime seminars at Wharton, and also for research support from Dan Mingelgrin. Two anonymous referees get special thanks. How Investors Interpret Past Fund Returns ABSTRACTThe literature documents a convex relation between past returns and fund flows of

On the informativeness of persistence for evaluating mutual fund performance using partial frontiers

“…Interestingly, in all panels, as in This evidence is similar to findings in the financial literature such as Carhart (1997), Lynch andMusto (2003), or Loon (2011), among others. Therefore, an interesting point to highlight is that the results yielded by partial frontiers, which maintain the advantages of both DEA and FDH (i.e.…”

“…For instance, Carhart (1997), Lynch and Musto (2003) and Bollen and Busse (2005) show different levels of persistence for the best and worst mutual funds. The rebalancing of the portfolio and the approach of different quantile levels is a useful procedure in finance for making the fund more robust.…”

Market Discipline and Internal Governance in the Mutual Fund Industry

“…Our model differs from the Lynch and Musto (2003) model in several aspects. First, Lynch and Musto (2003) do not allow for diseconomies of scale.…”

“…Furthermore, we are able to derive closed-form solutions for the value of the management company, accounting for both market discipline and the real option generated by optimal manager replacement. Lynch and Musto (2003) develop a two-period model to explain the convexity of the flow-performance relation. Their key insight is that underperforming funds will change their strategies while those outperforming will not.…”

“…Second, whereas Lynch and Musto (2003) analyze the decision to change strategies in a twoperiod model, we model the manager replacement decision in a fully dynamic framework, taking into account flow responses, replacement costs, and the option value of postponing the replacement. Third, although firing bad managers increases the convexity of the flowperformance relation, such a convexity exists in our model even without this consideration.…”