Recent literature in empirical finance is surveyed in its relation to underlying behavioral principles, principles which come primarily from psychology, sociology and anthropology. The behavioral principles discussed are: prospect theory, regret and cognitive dissonance, anchoring, mental compartments, overconfidence, over- and underreaction, representativeness heuristic, the disjunction effect, gambling behavior and speculation, perceived irrelevance of history, magical thinking, quasi-magical thinking, attention anomalies, the availability heuristic, culture and social contagion, and global culture. Theories of human behavior from psychology, sociology, and anthropology have helped motivate much recent empirical research on the behavior of financial markets. In this paper I will survey both some of the most significant theories (for empirical finance) in these other social sciences and the empirical finance literature itself. Particular attention will be paid to the implications of these theories for the efficient markets hypothesis in finance. This is the hypothesis that financial prices efficiently incorporate all public

This article presents evidence on persistence in the relative investment performance of large, institutional equity managers. Similar to existing evidence for mutual funds, we find persistent performance concentrated in the managers with poor prior-period performance measures. A conditional approach, using time-varying measures of risk and abnormal performance, is better able to detect this persistence and to predict the future performance of the funds than are traditional methods.

Due to differences in financial sophistication and agency relationships, we posit that investors use different criteria to select portfolio managers in the retail mutual fund and fiduciary pension fund industry segments. We provide evidence on investors ’ manager selection criteria by estimating the relation between manager asset flow and performance. We find that pension fund clients use quantitatively sophisticated measures like Jensen’s alpha, tracking error, and outperformance of a market benchmark. Pension clients also punish poorly performing managers by withdrawing assets under management. In contrast, mutual fund investors use raw return performance and flock disproportionately to recent winners, but do not withdraw assets from recent losers. Mutual fund manager flow is significantly positively related to Jensen’s alpha, a seemingly anomalous result in light of a relatively unsophisticated mutual fund client base. We provide evidence, however, suggesting that this relation is driven by a high correlation between

his support with the CDA/Spectrum database. We especially thank Russ Wermers for providing us with the characteristic-adjusted stock returns reported in DGTW (1997). We acknowledge the financial support from Mitsui Life Center in acquiring the CDA/Spectrum data. All errors are our own responsibility. On the Industry Concentration of Actively Managed Equity Mutual Funds The value of active fund management recently has become a central debate among researchers and practitioners. Mutual fund managers can deviate from the passive market portfolio by concentrating their holdings in specific industries. We investigate whether mutual fund managers are motivated to hold concentrated portfolios because they have investment skills that are linked to specific industries or whether they are motivated by agency problems that induce them to hold poorly diversified portfolios. Using U.S. mutual fund data from 1984-1999, we study the relationship between the industry concentration of mutual funds and their performance. Our analysis indicates that mutual funds differ substantially in their industry concentration, and that concentrated funds tend to follow distinct investment styles. Managers of more concentrated funds

Gruber (1996) finds evidence to support selection ability among active fund investors for equity funds listed in 1982. Using a large sample of equity funds, I find evidence that newly invested money is able to predict future fund performance, in that the equally weighted portfolios of funds that receive more money subsequently perform significantly better than those that lose money. There is no significant evidence that funds that receive more money subsequently beat the market, except for the small funds. There is some evidence that the

This study examines the determinants of mutual fund mergers and their subsequent wealth impact on shareholders of target and acquiring funds. Results indicate significant improvements in post-merger performance and a reduction in expense ratios for target fund shareholders. In contrast, acquiring fund shareholders experience a significant deterioration in post-merger performance. The net asset flows continue to remain negative for the combined fund in the year following the merger. The likelihood of a fund merger is inversely related to fund size for both within- and across-family mutual fund mergers. However, poor past performance is a significant determinant for only within-family mergers.

Systemic risk is commonly used to describe the possibility of a series of correlated defaults among financial institutions—typically banks—that occur over a short period of time, often caused by a single major event. However, since the collapse of Long Term Capital Management in 1998, it has become clear that hedge funds are also involved in systemic risk exposures. The hedge-fund industry has a symbiotic relationship with the banking sector, and many banks now operate proprietary trading units that are organized much like hedge funds. As a result, the risk exposures of the hedge-fund industry may have a material impact on the banking sector, resulting in new sources of systemic risks. In this paper, we attempt to quantify the potential impact of hedge funds on systemic risk by developing a number of new risk measures for hedge funds and applying them to individual and aggregate hedge-fund returns data. These measures include: illiquidity risk exposure, nonlinear factor models for hedge-fund and banking-sector indexes, logistic regression analysis of hedge-fund liquidation probabilities, and aggregate measures of volatility and distress based on regime-switching models. Our preliminary findings suggest that the hedge-fund industry may be heading into

Several studies measuring the flow of monies into and out of U.S. mutual funds note a convexity in the performance-flow relation and offer several explanations for the apparent investor insensitivity to poor performance. In this study investor response to past performance is measured in a different setting: the Australian wholesale funds market. The results confirm that, like the U.S. mutual fund investor, institutional investors in Australia react to recent performance. However, a similar response asymmetry is not detected in most tests. Evidence that small, young funds are potential drivers of the asymmetric response effect is also provided in this study. I. Introduction "One of the greatest mysteries in the mutual fund industry is why some investors stay with funds that consistently perform poorly." Goetzman and Peles, 1997 Several studies measuring the flow of monies into and out of mutual funds (e.g., Ippolito (1992) and Sirri and Tufano (1998)) note an asymmetry: recent top ...

We examine the effect that an initial 5-star Morningstar mutual fund rating has on future fund performance, strategy, risk-taking, expenses and portfolio turnover. Using a sample of diversified domestic equity funds from 1990’s we find that 3-years after a fund has received its initial 5-star rating, fund performance severely falls off. This result is robust across different performance measures and different samples of funds. We also find that after receiving their initial 5-star rating, the risk levels of funds rise and that the funds are not able to load on momentum stocks as well as they did before receiving the 5-star rating. These results suggest that funds, to some degree, alter their portfolios after receiving a 5-star rating and that investors should be very wary about using the 5-star rating as a signal of future 3-year performance. Key Words: Mutual Funds, Morningstar, Fund Ratings, Performance persistenceThe Kiss of Death: A 5-Star Morningstar Mutual Fund Rating? We examine the effect that an initial 5-star Morningstar mutual fund rating has on future fund performance, strategy, risk-taking, expenses and portfolio turnover. Using a sample of diversified domestic equity funds from 1990’s we find that 3-years after a fund has received its initial 5-star rating, fund performance severely falls off. This result is robust across different performance measures and different samples of funds. We also find that after receiving their initial 5-star rating, the risk levels of funds rise and that the funds are not able to load on momentum stocks as well as they did before receiving the 5-star rating. These results suggest that funds, to some degree, alter their portfolios after receiving a 5-star rating and that investors should be very wary about using the 5-star rating as a signal of future 3-year performance.

Incentive or performance fees for money managers are frequently accompanied by high-water mark provisions which condition the payment of the performance fee upon exceeding the maximum achieved share value. In this paper, we show that hedge fund performance fees are valuable to money managers, and conversely represent a claim on a significant proportion of investor wealth. The high-water mark provisions in these contracts limit the value of the performance fees. We provide a closed-form solution to the high-water mark contract under certain conditions. This solution shows that managers have an incentive to take risks. Our results provide a framework for valuation of a hedge fund management company. We conjecture that the existence of high-water mark compensation is due to decreasing returns to scale in the industry. Empirical evidence on the relationship between fund return and net money flows into and out of funds suggest that successful managers, and large fund managers are less willing to take new money than small fund managers. Please direct correspondence to: