NCPA - National Center for Policy Analysis

MUTUAL FUND SWITCHING LOWERS INVESTORS' RETURNS

March 29, 2006

It is a common practice for individual investors to shift money from one mutual fund to another in pursuit of better returns. In regard to future stock prices, says the National Bureau of Economic Research (NBER), such practice is nothing short of foolish.

The NBER demonstrates that "individual investors have a striking ability to do the wrong thing." They assert that individual investors in fact perform so poorly that one could use their mutual fund reallocations to predict future stock returns.

To discern the patterns, NBER calculated the mutual fund ownership of a stock that can be attributed to reallocation decisions as reflected in mutual fund investment flows (that is, purchases or sales of stock). According to researchers:

  • At the end of 1999, 18 percent of the outstanding Cisco shares -- tech stocks -- were owned by mutual funds; however, if flows had occurred proportionately to asset value, the level of mutual fund ownership would have been only 15 percent.
  • On average from 1980 to 2003, retail investors put their money into funds that invested in stocks with low future returns; however, mutual fund investors experience total returns that are significantly lower because of their reallocations.
  • Therefore, mutual fund investors are "dumb" in that their reallocations lose them money.
  • This dumb money effect is related to the value effect: money flows into mutual funds that own growth stocks and flows out of mutual funds that own value stocks.

There is a correlation between demand by individuals and supply from firms. When individuals buy more stock of a specific company via mutual fund inflows, the company increases the number of shares outstanding, supporting the view individual investors are dumb while smart firms exploit their demand for shares, says NBER.

Source: Matt Nesvisky, "Mutual Fund Switching Lowers Investors' Returns," NBER Digest, February 2006; based upon: Andrea Frazzini and Owen Lamont, "Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns," NBER Working Paper, no. 11526, August 2005.

For text:

http://www.nber.org/digest/feb06/w11526.html

For Frazzini and Lamont text:

http://papers.nber.org/papers/w11526

 

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