PODCAST:
WARNING: It’s No Longer a Safe Bet to Follow the Mutual
Funds
It
might seem like a safe bet to mimic the trading strategy of
mutual funds. But Russ Wermers, associate professor of
finance, cautions investors to be wary of blindly following
the herd. Wermers, with Nerissa Brown, PhD ’05, University
of Southern California, and Kelsey Wei, University of Texas
at Dallas, is coauthor of “Analyst Recommendations, Mutual
Fund Herding and Overreaction in Stock Prices,” a paper that
documents the tendency of mutual fund managers to follow
analyst recommendation revisions when they trade stocks and
the impact of such mutual fund “herding” on stock prices.
Herding is the tendency of funds to buy or sell the same
stocks during the same calendar quarter, more than would be
expected by random chance.
The authors analyzed quarterly stock trades by U.S.
equity mutual funds following the recommendation revisions
of sell-side analysts across all U.S. stocks from 1994 to
2003. When examining revision changes and herding
activities, they observed that when analysts revised stocks
upward, the mutual funds tended to respond by buying in
herds, and when stocks were revised downward, funds tended
to respond by selling in herds. The stocks bought by herds
had an initial increase in price, but after about six
months, the prices of those stocks went into a reversal and
dropped sharply. Stocks sold by herds experienced exactly
the opposite pattern—first they went down in price, but then
they rose again.
This indicated to Brown, Wei, and Wermers that mutual
fund managers are overreacting to the recommendations of
analysts. “This is the first time that anyone has found
solid evidence, on a widespread scale, that any type of
asset managers destabilize markets through their trades,
actually pushing prices around and away from the fundamental
prices of the shares,” says Wermers.
 Wermers
has looked at the way mutual funds affected the market
before, in research covering fund trading from 1975 to 1994
and published in the Journal of Finance in 1999. At the
time, he found that mutual funds acted as a stabilizing
force, driving stocks toward a fair price. Now mutual fund
managers are destabilizing the market. So what has changed?
Part of the answer may be that there are so many more mutual
funds now. .In 1994, mutual funds held 13 percent of all
equities. In 2005, they held 22 percent, about double the
share of ownership of the entire stock market. Mutual funds
also trade more, partly because trading costs have dropped
significantly. So, it is likely that far in excess of 22
percent of trading activity can be attributed to mutual
funds.
The authors worried that perhaps analysts and mutual
funds might simply be responding to the same external
signals, such as a change in the stock risk, earnings news,
or past returns, and funds might not be watching the
analysts at all. But, after controlling for such common
external influences, they found that mutual fund herding was
still strongly linked to analyst recommendations.
The professors also found that mutual funds that did
poorly over the past year were more likely to herd on
analysts’ signals, perhaps because managers of losing funds
are already at risk of losing their jobs and, thus more
likely to seek the safety of investing with the crowd. That
way, if they continue to perform poorly, at least they will
not stand out. “They seem to say to themselves ‘How can I
stay safe,’” says Wermers. “Winning funds see an analyst’s
recommendation and take a more thoughtful approach, perhaps
because they’re less worried about their reputations and
have a little more breathing room.”
This almost seems to argue for a contrarian investing
strategy—watch what the majority of mutual fund managers do,
and then do the opposite. But Wermers cautions that
individual investors should not take on such a strategy
without considering the substantial risks involved: with
many stocks, the reversal pattern did not hold, and
investors could lose a great deal of money trying to profit
on it.
For more information about this research, contact
rwermers@rhsmith.umd.edu. |
