6. Conclusion

Debate on the validity of evidence that some mutual funds have persistent positive risk-adjusted returns (Hendricks, Patel, Zeckhauser, 1993; Grinblatt and Titman, 1992; Brown et al., 1992) has overshadowed the significance of stronger evidence that some funds are sustained underperformers. In this paper we investigate how funds with mediocre or consistently poor performance are able to survive at all.

We estimate a partial-adjustment model of holdings in mutual funds assuming that investors choose funds based on recent risk-adjusted returns then compare it to an alternative model motivated by the representativeness heuristic.

"Statistical theory and the calculus of chance prescribe rules for combining strength and weight [of evidence]. For example, probability theory specifies how sample proportion and sample size combine to determine posterior probability. The extensive experimental literature on judgment under uncertainty indicates that people do not combine strength and weight in accord with the rules of probability and statistics. Rather, intuitive judgments are overly influenced by the degree to which the available evidence is representative of the hypothesis in question." (Griffin and Tversky, 1992, p. 413)

Jensen’s alpha prescribes a rule for combining information on funds’ returns and systematic risk to determine risk-adjusted performance. We find that investors do not combine returns and risk in accord with this performance measure. Rather, intuitive judgments about fund performance are overly influenced by extreme recent returns unadjusted for differential risk. Further, investors’ judgments about future performance are insensitive to moderate differences in expenses of funds, ignoring the predictive validity of small differences in expenses for long-run performance.

If investors regularly readjusted holdings in funds, ignoring differences in risk and expenses might be advantageous: Hendricks, Patel and Zeckhauser (1993) argue that fund performance persists over short horizons so that portfolios of funds with high returns, readjusted quarterly, may yield superior returns. Instead, in the aggregate, investors appear to combine insensitivity to differences in risk and expenses with extremely slow adjustment of fund holdings allowing mediocre and poorly performing mutual funds to persist. Investors select funds using criteria unsuited to the time periods they hold funds. Poor performers can persist even when Ippolito’s (1992) definition of investor vigilance (reaction of net sales to risk-adjusted performance) is satisfied.

Money managers are paid for attracting money, not for generating good risk adjusted returns. Mutual fund managers receive a fee based on the total assets of the fund (often 0.5%); even the use of crude incentive fees is rare (Ippolito, 1992). The evidence in this paper indicates that managers of no-load, growth mutual funds might find it easier to increase earnings with higher risk rather than higher risk-adjusted returns. The race is not always to the swift, nor the battle to the strong, nor yet favor to money managers of skill.