Tax Calendar Effects in the Municipal Bond Market: Tax‐Loss Selling and Cherry Picking by Investors and Market Timing by Fund Managers

Examining municipal bond returns, bond fund flows and buying activities by fund managers over the period 1990–2009, we find evidence of tax calendar‐related rational opportunistic trading patterns by fund investors and fund managers. Specifically, fund shareholders conduct tax‐loss selling in December and re‐invest in January. In April, June, and September, fund investors rationally cherry pick to sell their shares of short‐term bond funds instead of their shares of long‐term bond funds to raise cash to pay estimated taxes. Unlike fund shareholders, fund managers adopt a contrarian strategy of buying in December and selling in January.     

Front-Running by Mutual Fund Managers: A Mixed Bag

This paper evaluates the welfare implications of front-running by mutual fund managers. It extends the model of Kyle (1985) to a situation in which the insider with fundamentals-information competes against an insider with trade-information and in which noise trading is endogenized. Noise traders are small investors trading through mutual funds to hedge non-tradable or illiquid assets. The insider with trade-information is one of the fund managers. We find that her front-running activity reduces the liquidity costs of her customers, but it also reduces their hedging benefits. As a result, the customers of the front-running manager may be worse off and place smaller orders. The opposite is true, however, for those investors who are not subject to front-running. In aggregate, front-running has either no or positive consequences for welfare.     

Mandatory Portfolio Disclosure,Stock Liquidity,and Mutual Fund Performance

We examine the impact of mandatory portfolio disclosure by mutual funds on stock liquidity and fund performance. We develop a model of informed trading with disclosure and test its predictions using the May 2004 SEC regulation requiring more frequent disclosure. Stocks with higher fund ownership, especially those held by more informed funds or subject to greater information asymmetry, experience larger increases in liquidity after the regulation change. More informed funds, especially those holding stocks with greater information asymmetry, experience greater performance deterioration after the regulation change. Overall, mandatory disclosure improves stock liquidity but imposes costs on informed investors.     

Reputation stretching in mutual fund starts

This study examines the role of reputation stretching in the context of mutual funds. We show that the reputation stretching strategy increases net fund inflows to new funds run by well-performing fund managers and yields a net increase of fund inflows to fund families. Reputable fund managers exhibit one-year performance persistence for managing new funds, which can help investors assess managers when selecting funds. We also find that the decrease in information asymmetry associated with managerial reputation benefits investors by leading to an increase in new fund returns in the short run, compared to those of new funds run by managers without track records. Overall, the reputation stretching strategy benefits both investors, by reducing information asymmetry and improving investment returns, and fund families, by increasing net fund inflows to new equity funds.     

Is trading behavior stable across contexts? Evidence from style and multi-style investors

In this paper we study priming of identity within the context of inherent vs. contextual financial decision making. We use a sample of individual trading accounts in equity-style funds taken from one fund family to test the hypothesis that trading styles are inherent vs. contextual. Our sample contains investors who invest either in a growth fund, a value fund, or both. We document behavioral differences between growth fund investors and value fund investors. We find that their trades depend on past returns in different ways: growth fund investors tend towards momentum trading and value fund investors tend towards contrarian trading. These differences may be due to inherent clientele characteristics, including beliefs about market prices, specific personality traits and cognitive strategies that cause them to self-select into one or the other style. We use a sample of investors that trade in both types of funds to test this proposition. Consistent with the contextual hypothesis, we find that investors who hold both types of funds trade growth fund shares differently than value fund shares.     

Information, trade, and derivative securities

Hellwig's (1980) model is used to analyze the value of improvingtrading opportunities by more frequent trading in the underlyingasset, or by trading in a derivative asset. With multiple tradingsessions, uninformed investors behave as rational trend followers,while more informed investors follow a contrarian strategy.As trading becomes continuous, Pareto efficiency is achieved.With trading in an appropriate derivative security, Pareto efficiencymay be achieved in only a single round of trading. All derivativeclaims are then priced on Black and Scholes (1973) principlesand, in the absence of further supply shocks, no trading willtake place in subsequent trading rounds.     

Follow the leader: fund managers trading in signal‐strength sequence*

When fund managers trade sequentially in the same direction, the information confirmation hypothesis predicts the long‐term profitability of the leader trade to be increasing in the number of subsequent trades. The information cascade hypothesis predicts a non‐positive relationship. Using active equity funds’ daily trading data, we document a transition from information confirmation to information cascades as the number of followers increase. We find that highly disguised multiple‐broker packages exhibit higher market impact, higher long‐term returns and are associated with fewer followers. Our study also documents that lead fund managers face portfolio risk constraints in trading on private information.     

CARE/CEASA Roundtable on Managing Uncertainty and Risk

Two distinguished Morgan Stanley “alumni” discuss how their management of risk and uncertainty has not only preserved but increased the profitability of their businesses. In both cases—one involving a commodities trading operation and the other a long‐short hedge fund—the key has been to find cost‐effective ways to “cut off the left tails” of the distribution by avoiding naked long or short positions and creating option‐like payoffs with limited downside. In the case of the hedge fund, the combination of longs and shorts with the use of other risk‐reducing strategies has enabled the fund's managers to produce twice the market's returns with only half the volatility (and only one losing year) during the 18‐year life of the fund. In the case of the commodities trading operation, the strategy is described as combining ownership of physical assets with the use of option pricing models to create what amount to “long gamma positions in the asset” that “produce payoffs regardless of whether the asset goes up or down in value.”     

A tale of feedback trading by hedge funds

This paper studies the extent of feedback trading at the factor level by hedge fund managers. We show that fund managers continuously adjust their exposure to different risk factors conditional on the recent performance of these factors. The majority of managers apply a positive feedback strategy, whereas the remaining managers use a negative feedback strategy. In addition, we find some evidence for factor timing ability, although managers appear to be more backward looking than forward looking. We show that positive feedback trading can be beneficial to fund performance in our setup. If managers applied the positive feedback strategy more aggressively, however, they could benefit more from it. As such, the “smart switching benchmark” can be used to assess the risk-adjusted performance of hedge funds.     

Decomposing the persistence of international equity flows

The portfolio flows of institutional investors are widely known to be persistent. What is less well-known, however, is the source of this persistence. One possibility is the ‘informed trading hypothesis:’ that persistence arises from autocorrelated trades of individual investors who believe they have information about value and who face an imperfectly liquid market. Another possibility is that there are asynchroneities with respect to investment decisions across funds, across investments, or both. These asynchroneities could be due to wealth effects (across investments for a single fund), investor herding (across funds for a single investment), or generalized contagion (across funds and across investments). We use daily data on institutional flows into 21 developed countries by 471 funds to measure and decompose aggregate flow persistence. We find that the informed trading hypothesis explains about 75% of total persistence, and that the remaining amount is attributable entirely to cross-fund own-country persistence. While asynchroneities across funds investing in the same country are important, asynchroneities across countries, either within a given fund, or across funds, are not important. The cross-fund flow lags we identify might result from different fund investment processes, or from some funds mimicking others' decisions. We reject the hypothesis that wealth effects explain persistence.     

The role of institutional investors in seasoned equity offerings

Do institutional investors possess private information about seasoned equity offerings (SEOs)? If so, do they use this private information to trade in a direction opposite to this information (a manipulative trading role) or in the same direction (an information production role)? We use a large sample of transaction-level institutional trading data to distinguish between these two roles of institutional investors. We explicitly identify institutional SEO allocations for the first time in the literature. We analyze the consequences of the private information possessed by institutional investors for SEO share allocation, institutional trading before and after the SEO and realized trading profitability, and the SEO discount. We find that institutions are able to identify and obtain more allocations in SEOs with better long-run stock returns, they trade in the same direction as their private information, and their post-SEO trading significantly outperforms a naive buy-and-hold trading strategy. Further, more pre-offer institutional net buying and larger institutional SEO allocations are associated with a smaller SEO discount. Overall, our results are consistent with institutions possessing private information about SEOs and with an information production instead of a manipulative trading role for institutional investors in SEOs.     

The profitability,costs and systematic risk of the post-earnings-announcement-drift trading strategy

This paper re-examines the profitability of the post-earnings-announcement-drift (PEAD) trading strategy using a practical simulation approach that aligns with a fund manager’s investment perspective. It allows us to calculate the break-even transaction costs of following a PEAD strategy, and permits the explicit incorporation of transaction costs. Using US data from 1974 to 2007, we show that the traditional event-study method understates the risk and overstates the abnormal return of the PEAD strategy. Accounting for transaction costs in a practical simulation framework, we show there is no abnormal return (alpha) from the PEAD strategy in multi-factor asset pricing regression analyses. These results are robust to sub-period analyses and alternative transaction cost measures. The effects of intraday timing and information risk on the PEAD strategy are also explored. Overall, our study shows that the practical aspects of implementing the PEAD strategy are vitally important to evaluating the risk and return of the strategy. We provide a practical, analytical tool that can be directly adopted by fund managers to study the PEAD strategy with their institutional parameters of transaction costs and market timing.     

Style chasing by hedge fund investors

This paper examines whether investors chase hedge fund investment styles. We find that better-performing and more popular styles are rewarded with higher inflows in subsequent periods. This indicates that investors compare hedge fund styles in terms of recent performance and popularity, and they subsequently reallocate funds from less successful to more successful styles. Furthermore, we find evidence of competition between individual hedge funds of the same style. Funds outperforming the other funds in their styles and funds whose inflows exceed the average flows in their styles experience higher inflows in subsequent periods. One of the reasons for competition among same-style funds is investors’ search for the best managers. The high minimum investment required to invest in a hedge fund limits investors’ diversification opportunities and makes this search particularly important. Finally, we show that hedge fund investors’ implementation of style chasing in combination with intra-style fund selection represents a smart strategy.     

Do Fund Flow‐Return Relations Depend on the Type of Investor? A Research Note

This study investigates whether the relation between aggregate fund flow and market returns differs between retail and institutional funds. For the retail fund sample, we document a contemporaneous relation between flow and market returns and also find evidence of feedback trading. In contrast, there is little evidence of a relation between flow and market returns for the institutional fund sample. Consequently, it appears that retail and institutional fund investors use different investment strategies, with retail investors following a more naive strategy. We find no evidence of flow inducing price pressure for either type of fund.     

Derivative use,fund flows and investment manager performance

Prior literature which examines the use of derivatives by investment managers does not discern between different types of derivative trading strategies. This study is the first to examine and gather data on a particular type of derivative trading strategy undertaken by investment managers. We examine the extent to which equity fund managers use index futures to manage fund flows and the effect this has on their alpha and market timing measures of performance. Our results show that funds that do not use derivatives exhibit lower returns and negative market timing skills when they experience fund flow. The performance of funds that use derivatives, however, is independent of investor’s liquidity demands. In fact, the unconditional performance of the average user fund is statistically equivalent to the performance of the average non-user fund conditional on zero fund flow. Our results provide evidence that derivatives can be beneficial for mutual fund holders under certain conditions.     

Do foreign exchange fund managers behave like heterogeneous agents?

This paper estimates an Heterogeneous Agent Model (HAM) on currency trader indices to explain the large shifts in profitability in currency styles surrounding the global financial crisis. In the model, fund managers allocate capital conditional on recent performance to a value strategy, a momentum strategy, and a carry strategy. Subsequent estimation results reveal that (1) a large part of the behavior of currency managers can indeed be described by these three simple strategies, and (2) currency managers shift capital from recent winning styles to recent losing styles, and hence apply a negative feedback strategy. We finally show that a negative feedback strategy is indeed optimal, but currency managers could improve performance by applying it less aggressively if they were able to.     

The Inter-Temporal Behavior of Informed and Uninformed Traders

The purpose of this study is to investigate the inter-temporal trading behavior of informed and uninformed investors. We estimate a variation of the market microstructure model developed in Easley, Keifer, O'Hara, and Paperman (1996) and document the day-of-the-week pattern in informed and uninformed trading, as well as the probability of an information event and the probability of bad news. Using bootstrapped distributions, we show that the probability of trading against informed investors follows a U-shape pattern from Monday to Friday. Cross-sectional regression results suggest that inter-temporal patterns between informed and uninformed traders can generate observed patterns in liquidity provision costs.     

Cash flow timing skills of socially responsible mutual fund investors

This paper studies, for the first time, the cash flow timing skills of socially responsible (SR) mutual fund investors. Our findings show that SR investors neither worsen nor improve their returns according to their cash flow timing decisions, although they show good timing for net purchase and perverse timing for net withdrawal decisions. When controlling for fund characteristics, investors in larger, institutional, with longer mean manager tenure, lower expense ratio, no load, lower mean turnover ratio and a fee level below the average funds, show better timing results; in other words, sophisticated and better informed investors make better cash flow timing decisions. Controlling for SR strategy, green fund investors (our proxy for profit-seeking investors) had the worst results (similar to those obtained for conventional investors in the prior literature), and religious fund investors (our proxy for the values-driven profile) had results that were most different from conventional investors.     

Connected Stocks

We connect stocks through their common active mutual fund owners. We show that the degree of shared ownership forecasts cross‐sectional variation in return correlation, controlling for exposure to systematic return factors, style and sector similarity, and many other pair characteristics. We argue that shared ownership causes this excess comovement based on evidence from a natural experiment—the 2003 mutual fund trading scandal. These results motivate a novel cross‐stock‐reversal trading strategy exploiting information contained in ownership connections. We show that long‐short hedge fund index returns covary negatively with this strategy, suggesting these funds may exacerbate this excess comovement.     

Trading patterns of big versus small players in an emerging market: An empirical analysis

This study uses a Vector Autoregressive (VAR) model to examine interdependencies among institutional investors, big individual investors, and small individual investors, and the effects of their trading on stock returns on the Taiwan Stock Exchange (TSE). The results imply that, during the sample period, big individual investors are the most well informed players; their trading affects not only stock returns but also small individual investors. Small individual investors are not well informed and are slow learners. Their orders to trade tend to provide liquidity to institutional and big individual investors, but there is no compensation for their liquidity services. We find that institutional investors follow neither positive-feedback nor negative-feedback trading strategies. Overall, the responses to shocks, except for those of small individual investors, decay quickly, indicating that the TSE can absorb shocks quickly and efficiently. Our analysis implies that small individual investors would be better off institutionalizing their investment decisions (e.g., by investing in mutual funds).