Swedroe: Performance Chasing & Factor Returns

Data suggest naive investors can have a temporary effect on factor returns.

My ETF.com post of March 8 discussed the research findings of Itzhak Ben-David, Jiacui Li, Andrea Rossi and Yang Song, authors of the November 2018 study “What Do Mutual Fund Investors Really Care About?” They found that naive retail investor fund flows are driven by Morningstar ratings and raw recent returns (neither of which are adjusted for risk/exposure to common factors found in asset pricing models).

Factor Fragility

Shiyang Huang, Yang Song and Hong Xiang, authors of the January 2019 study “Fragile Factor Premia,” investigated whether the cash flows of individual mutual fund investors (who are largely ignorant about systematic risks when allocating capital among mutual funds) impact the premium to common factors found in asset pricing models.

They estimated mutual fund flow-induced trading (FIT), which measures the magnitude of flow-driven trading by the aggregate equity mutual fund industry on a particular stock in a given quarter. They use FIT rather than the entire realized trading of mutual funds because FIT captures only those trades driven by the demand shifts from mutual fund investors, which are largely ignorant about fundamentals.

Their study covered the period 1980 to 2017 and almost 5,000 mutual funds. The following is a summary of their findings:

• Mutual fund trading has a considerable price impact on individual stocks.
• Mutual fund flows are largely ignorant about systematic risks.
• Aggregate mutual fund flow-induced trades across the size and book-to-market spectrum significantly influence the size and value premia. For example, a one-standard-deviation change of the aggregate factor-level flow-induced trades is associated with a 6.6% change in the size premium return and a 6.5% change in the value premium per year, respectively.
• Verifying that mutual fund flow-induced trades are nonfundamental, flow-induced effects on factor returns significantly revert over longer horizons. For example, a one-standard-deviation increase in the difference of flow-induced trades into value stocks and flow-induced trades into growth stocks over the prior five years, on average, predicts a 4.2% decrease in the value premium over the next year.
• Returns of the six Fama-French (FF) size and book-to-market portfolios are largely determined by the uninformed mutual fund flow-induced trades—there is no association between FIT and firm size or book-to-market ratios. Within each of the six FF portfolios, stocks with higher FIT have higher return performance. For example, stocks with a top-quartile FIT, on average, outperform the bottom-quartile-FIT stocks in the same portfolio by about 1% per month, although they have similar firm size and book-to-market ratios.
• Across the FF size and book-to-market portfolios, growth stocks with a positive FIT significantly outperform value stocks with a negative FIT, controlling for firm size. Controlling for book-to-market ratio, large-cap stocks with a positive FIT significantly outperform the negative-FIT small-cap stocks.
• The size (value) premiums are high in the periods when there are more flow-driven trades into small-cap (value) stocks relative to large-cap (growth) stocks, and vice versa. The economic magnitude is significant: For example, a one-standard-deviation change of the aggregate FIT across the size spectrum is positively associated with a 6.6% change in the annual size premium.
• Flow-induced performance is more pronounced in the more recent sample period, consistent with the rise in the size of the mutual fund industry over time.
• The expected volatilities of mutual funds’ flow-induced trades strongly predict future factor volatilities.

Huang, Song and Xiang concluded: “The factor-level flow-induced trading is a statistically strong and economically significant driver of factor returns.” They added: “Our results highlight the importance of non-fundamental demand shocks in determining factor premia and factor volatilities.”

Summary

The authors’ results have important implications. First, it seems to me that nonfundamental demand shocks caused by naive retail investor fund flows help explain the momentum factor. Second, long-term investors (and there should be no other kind) should ignore the short-term performance of factors as they are highly influenced by “noise traders.” The evidence demonstrates that, over the longer term, the pricing impacts of these naive investors are reversed.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.