Mutual Fund Investor Behavior Across the Business Cycle

Abstract

Mutual fund investor behavior changes across the business cycle. In economic expansions, investors strongly display the documented behaviors of chasing returns and searching for managerial skill. Expansion investors earn higher returns and alphas by pursuing this strategy, but this result is partially explained by the momentum effect. In contrast, recession investors do not chase returns and exhibit a weaker tendency to seek alpha. Even before controlling for momentum, no smart money effect exists in recessions. Instead of chasing performance, recession investors make investment decisions to change their exposure to aggregate risk factors. Investors tend to avoid funds with exposure to the market and book-to-market factors during recessions, while they show the opposite pattern in expansions.