How Investors Interpret Past Fund Returns
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- Author(s): Anthony W. Lynch, David K. Musto
- Published: Sep 11, 2003
- Pages: 2033-2058
- DOI: 10.1111/1540-6261.00596
The literature documents a convex relation between past returns and fund flows of mutual funds. We show this to be consistent with fund incentives, because funds discard exactly those strategies which underperform. Past returns tell less about the future performance of funds which discard, so flows are less sensitive to them when they are poor. Our model predicts that strategy changes only occur after bad performance, and that bad performers who change strategy have dollar flow and future performance that are less sensitive to current performance than those that do not. Empirical tests support both predictions.