Do stock prices reflect all future cash flows or is the market myopic and looks too much at recent performance and near term cash flows? This is an enormously important question. Jin tries to answer it in the context of mutual fund investors. He finds that short term thinking is alive and well and can have important implications on efficiency.
We know that investors chase "hot funds" (see Sirri and Tufano-1998). But what are the implications of this (and other types of short-term thinking)? Li finds that short term thinking on the side of investors flows forward and leads to short term thinking by mutual fund managers. Of course, this is expected if the manager is under pressure to report strong results, but the paper is is an interesting look at this none-the-less.
Given investors chase hot returns and managers are often dimissed for poor performance, fund managers face pressure to increase returns in the short run.
In Li's words:
"fund managers face large incentives to perform in the short run. Such incentives largely come in the form of increased fund inflow and thus asset under management on the upside, and firing on the downside."The author examines this by looking at mutual fund holdings and returns and by creating measures of investor "short-termism."
And the findings? Jin finds that
1. "Flow-to-performance sensitivity is...positively correlated with turnover....a measure of input short-termism, is positively correlated with turnover
and negatively correlated with the average remaining holding periods of fund
investments. All correlations are statistically significant at the 1% level."
2. Short-termism has increased over the past 40 years.
3. "Higher flow-to-performance sensitivity significantly decreases
average remaining holding period and significantly increases fund turnover"
4. The reason for the short-term thinking flows from the fund's investors who behave in a short-term manner.
"Further tests of causality suggest that fund manager investmentThe potential consequences of these findings are huge. Again in the author's words:
short-termism is caused by investor short horizon, but not the other way round."
"Excessive fund manager focus on short horizon investments will likely affect asset prices, by inflating the price of the most liquid assets, which can be quickly resold without large price impact. On the other hand, long term investments could be the “neglected asset class” and thus might be less efficiently priced. "
Additionally, if investors (and institutions) are more short-term oriented, then there may be serious implications in the monitoring and corporate goverenance of firms.
"If institutions only invest for the short run, they might not have much interest to monitor management or participate in active governance.
Furthermore, corporate managers might react to the pressure of their
institutional investors by pursuing myopic investment decisions."
This finding will unfortunately give managers reason to doubt market efficiency and to argue that their "long-term" interests are different than the "myopic" stock market. Look for it to be used not only by mutual fund managers, but also any manager trying to increase entrenchment or argue for pet projects.
Jin, Li, "How Does Investor Short-termism Affect Mutual Fund Manager Short-termism" (February 27, 2005). EFA 2005 Moscow Meetings Paper. http://ssrn.com/abstract=675262