Swedroe: Which Factors Really Matter To Investors

November 30, 2016

In a recent article, I discussed the findings from a study by Brad Barber, Xing Huang and Terrance Odean, “Which Factors Matter to Investors? Evidence from Mutual Fund Flows,” which appeared in the October 2016 issue of The Review of Financial Studies.

In their paper, the authors investigated whether investors tend to consider common equity factors when assessing mutual fund managers. In other words, do investors attempting to identify a skilled active manager strip out the returns that can be traced to a mutual fund’s exposure to the investment factors known to explain cross-sectional equity returns?

In a perfectly rational world, fund flows should only respond to alpha, and not what is simply beta (loading on, or exposure to, a factor). They found, however, that the single-factor capital asset pricing model (CAPM), with market beta as its sole explanatory factor, did the best job of predicting fund-flow relations.

Market Risk Correlation To Fund Flows

This result implies that investors primarily tend to consider mutual funds’ market risk when evaluating performance, and that it is positively correlated with fund flows. The authors found that while investors do not completely ignore other factors that affect fund performance, they place less emphasis on the size and value factors than they do on market risk. In addition, they found no evidence that investors pay attention to the momentum factor.

Interestingly, Barber, Huang and Odean also found that investors who buy mutual funds from the broker-sold channel respond more to factor-related returns than investors buying in the direct-sold channel. This means that investors in the former channel are likely attributing returns to fund managers’ skill rather than to the factors that are responsible for the returns. The results are consistent with the notion that investors in the broker-sold channel are less sophisticated in their assessment of fund performance than investors in the direct-sold channel.

Furthermore, the authors found that investors buying in the direct-sold channel, as well as wealthier investors (more sophisticated investors), use more sophisticated models to assess fund managers’ skill, taking into account a fund’s exposure to factors (such as size and value) rather than attributing the excess returns to manager skill.

‘Unaware Of Other Factors That Drive Returns’

Barber, Huang and Odean concluded: “Our empirical analysis has revealed that investors behave as if they are concerned about market risk, but are largely unaware of other factors that drive equity returns. We have found some evidence that investors attend to the value, size, and industry tilts of a fund when assessing managerial skill, but these effects are much weaker than those we observed for a fund’s beta. Moreover, we have found that investors strongly respond to the factor-related return associated with a fund’s Morningstar-style category. Since the category-level return is not under the control of the manager, this result suggests some mutual fund investors confuse a fund’s category-level performance and manager skill.”

The authors also observed that, when evaluating a fund, investors must first know the factor-related return in order to adjust for it. They write: “Sophisticated investors will seek out this information. But less sophisticated investors may not be aware of size, value, momentum, or industry returns. The market’s performance, however, is ubiquitously reported. This may be one reason why investors do pay attention to market risk when evaluating mutual fund managers.”


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