How Investors Interpret Past Fund Returns

Authors

  • Anthony W. Lynch,

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    • 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.
  • David K. Musto

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    • 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.

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.

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