Mispriced Stocks And Mutual Fund Performance by SSRN

Doron Avramov

Hebrew University of Jerusalem

Si Cheng

Queen’s University Management School

Allaudeen Hameed

National University of Singapore (NUS) – Department of Finance

May 15, 2015


Using a broad set of market anomalies to identify overpriced stocks, we argue that the propensity for active mutual funds to hold such stocks reflects fund managerial skill. We find that funds that hold the most overpriced stocks attract capital flows, particularly following high sentiment periods. These funds also purchase more overpriced stocks during episodes of fund inflows and reduce their holdings of less overpriced stocks when they face outflows, reflecting low selection ability. Poor stock selection skill during high sentiment periods generates a strong predictive relation between fund level overpricing and subsequent fund performance. The average negative alpha characterizing the mutual fund industry is attributable to 20% of the most overvalued funds.

Mispriced Stocks And Mutual Fund Performance – Introduction

Recent statistics from the Investment Company Institute shows that total net assets managed by 3,264 U.S. active equity funds exceed six trillion dollar in April 2015. Such funds aim to create value for their investors through managerial skills in stock picking and market timing (e.g., Fama (1972), Brinson, Hood, and Beebower (1986), Daniel, Grinblatt, Titman, and Wermers (1997)). As mutual funds typically undertake long-only positons, stock picking skills essentially amount to detecting undervalued investments.

However, rational and behavioural asset pricing theories have typically excluded the possibility of undervalued investments. Instead, such theories have acknowledged the possibility that, at least based on public information, stock prices could exceed their discounted value of expected future dividends. Notably, Miller (1977) asserts that asset prices reflect the views of the more optimistic investors, when there are heterogeneous beliefs about fundamental values and impediments to short selling. Similarly, the basic insight in Harrison and Kreps (1978) is that when agents agree to disagree and short selling is not possible, asset prices may exceed their fundamental value as investors are willing to pay more for the right to sell the asset in the future. The positive feedback economy of De Long, Shleifer, Summers, and Waldmann (1990) also recognizes the possibility of overpricing ? arbitrageurs do not sell or short an overvalued asset, but rather buy it, in anticipation of future price increases due to further buying by trend chasing investors.

In this paper, we investigate whether the propensity of active mutual funds to overweight overvalued stocks reflects managerial skill and, in turn, predicts the cross sectional differences in fund performance. To pursue this task, we propose a new measure for fund overpricing ? the investment value-weighted average of overpricing of stocks held by the fund. Stock overpricing is computed following Stambaugh, Yu, and Yuan (2013) on the basis of eleven anomalies which survive the exposure to the three common factors in Fama and French (1993). Specifically, funds overweighting stocks that are financially distressed, with higher equity issuance, higher accruals, higher operating assets, lower past six-month returns, lower gross profitability, higher asset growth, lower return on assets, and higher abnormal capital investment, other things being equal, exhibit higher overpricing.

Mutual Fund

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