Returns-Chasing Behavior, Mutual Funds and Beta's Death

Abstract

I develop an agency model where returns-chasing behavior by mutual fund investors causes beta not to be priced to the degree predicted by the standard CAPM. Mutual fund investors chase returns through time, precipitating unusually large aggregate cash inflows into mutual funds just after dramatic market runups. Mutual fund investors also chase returns cross-sectionally across funds. Each period, mutual funds compete in tournaments where the highest-performing funds capture the largest fraction of the aggregate inflows into the mutual fund sector. The interaction between these two flow-performance relationships induces an asymmetry in payoffs to mutual funds such that equity fund managers care most about outperforming peers during bull markets. Since high-beta stocks tend to outperform low-beta stocks in up markets, active fund managers tilt their portfolios toward high-beta stocks, reducing the expected return to these securities in equilibrium. Thus, the presence of actively-managed mutual funds causes beta risk to be priced to a lesser degree than otherwise. Interestingly, the literature suggests that beta died in the early 1980s, coinciding with the spectacular growth of the mutual fund industry in the U.S. To support the model's time-series flow-performance assumption, I show empirically that market returns have a large economic impact on subsequent aggregate mutual fund flows. In addition, data on mutual fund holdings support the model's prediction that the aggregate stock portfolio held by equity mutual funds is over-weighted in high-beta stocks relative to the overall market.