Kidnapped mutual funds: Irrational preference of naive investors and fund incentive distortion

Xiaochen Chang, Songlin Guo and Junkai Huang

International Review of Financial Analysis, 2022, vol. 83, issue C

Abstract: This study documents that mutual fund investors in Chinese stock markets confuse factor-related returns (FRR) with active alpha. This revealed preference “kidnaps” mutual funds to chase FRR instead of alpha. The observed distorted incentive is intensified among less sophisticated groups as evidenced by investor type and fund-rating heterogeneity. Investors' biased skill assessment is irrational, even if FRR is a vital part of investors' utility function, as there is performance reversal for funds assessed as top performers. We further showed that a distorted incentive to chase FRR undermines mutual funds' willingness to generate alpha by combating fundamental mispricing. Mutual funds cater to investors' preferences by creating more speculative short-term factor timing and holding more lottery-like stocks. Our findings question the widely held belief of the sophisticated Bayesian-agent paradigm in household financial decision-making and cast doubt on institutions' willingness to address mispricing, as suggested by the efficient market hypothesis.

Keywords: Mutual funds flow; Factor-related returns; Investor sophistication; Incentive mismatch; Fund trading behavior (search for similar items in EconPapers)
JEL-codes: G11 G23 G41 (search for similar items in EconPapers)
Date: 2022
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finana:v:83:y:2022:i:c:s1057521922002356

DOI: 10.1016/j.irfa.2022.102279

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