Smart fund managers? Stupid money?

Abstract

We develop a model of mutual fund manager investment decisions near the end of quarters. We show that when investors reward better performing funds with higher cash flows, near quarter-ends a mutual fund manager has an incentive to distort new investment toward stocks in which his fund holds a large existing position. The short-term price impact of these trades increase the fund's reported returns. Higher returns are rewarded by greater subsequent fund inflows which, in turn, allow for more investment distortion the next quarter. Because the price impact of trades is short-term, each subsequent quarter begins with a larger return deficit. Eventually, the deficit cannot be overcome. Thus, our model leads to the empirically observed short-run persistence and long-run reversal in fund performance. In doing so, our model provides a consistent explanation of many other seemingly contradictory empirical features of mutual fund performance.JEL Classification: D82, G2, G14. Keywords: turn-of-quarter effect, painting the tape, mutual fund performance, investment distortion. * Richard Martin's master's essay under the direction of the first author was a building point for this research. We greatly appreciate Harvey Westbrook Jr.'s significant contributions to early drafts. We are also grateful for comments received from two anonymous referees, Chris Brooks, Murillo Campello, Duane Seppi, and seminar participants at Queen's University, St. Francis Xavier University, the Northern Finance Association meetings, the Financial Management Association European meetings, and the Multinational Finance Society meetings. We develop a model of mutual fund manager investment decisions near the end of quarters.We show that when investors reward better performing funds with higher cash flows, near quarter-ends a mutual fund manager has an incentive to distort new investment toward stocks in which his fund holds a large existing position. The short-term price impact of these trades increase the fund's reported returns. Higher returns are rewarded by greater subsequent fund inflows which, in turn, allow for more investment distortion the next quarter. Because the price impact of trades is short-term, each subsequent quarter begins with a larger return deficit. Eventually, the deficit cannot be overcome. Thus, our model leads to the empirically observed short-run persistence and long-run reversal in fund performance. In doing so, our model provides a consistent explanation of many other seemingly contradictory empirical features of mutual fund performance.JEL Classification: D82, G2, G14.

Market Manipulation: A Survey

“…Their model demonstrates that closing call auctions reduce manipulation and enhance price efficiency. A recent model of a mutual fund manager's investment decision (Bernhardt and Davies, 2009) suggests that fund managers have incentives to use short‐term price impacts to manipulate closing prices at the ends of reporting periods.…”

Portfolio Pumping and Managerial Structure

“…For instance, Bhattacharyya and Nanda (2013) develop an equilibrium model where managers have incentives to alter the closing prices of their security holdings. Bernhardt and Davies (2009) show that portfolio pumping is persistent: the mutual funds involved in portfolio pumping in one quarter are likely to do it again in the following quarter.…”

The Phenomenon of Abnormal Net Redemption in Chinese Fund Market

“…Huang et al's (2007) [11]conclusion is similar to Karceski's(2002). Bernhardt et al(2008) [12] researched about the fund manager decision model and discerned that investors invest more capital to reward good performing funds, motivating the manager to buy the large weight stock at the end of the quarter to raise the fund's price, and attracting more investment by increasing the return in a stage of the earning. Shrider (2009) [ 13 ]found that the investors redeem more historically poor performing funds and tend to purchase the ones which are historically good performing and currently at a bottom price.…”