Why might investors persist in believing fund managers are able to outperform their benchmarks on a consistent basis whereas the research evidence is inconsistent with this belief?

1. Introduction

The aim of this paper is to provide any academic evidence and theories concerning the main drivers of individual investors' decision making and their reasons to feel confident over the success of active fund management. Our report weighs against the evidence of rational and measurable explanations supporting active managers and their stock picking skills. Not underestimating the power of communication, there is a provision of research studies to show how media and advertising are employed in selling managers' superior skills and their affect on investors' decision making. Next the report tries to understand and solve the puzzle about investors' beliefs in managers' adding value. For this purpose there is reference on the behavioural finance implications and some of the heuristics and biases that can enrich the explanation for most of the investors' behaviour.

2. Rationality

2.1. The benefits from fund managers

Investors' decision to invest in active funds is primary driven by the benefits of large scale investing. Bodie et al. (2008) identified several important functions that allow small investors to benefit from “teaming up” their money. Such are the record keeping and administration, diversification, professional management and the lower transaction costs as result of trading in larger blocks of securities.

In addition, investors argue that the market is a supply pool of managers with different investing styles and that some of them can outperform the index while others cannot. Platinum Capital fund for example, managed by Kerr Neilson, outperformed MSCI world stock index by 35% in 2009. The fund's strategy was based on investing in financial distress companies but with large unexploited potentials for future growth as well as going short on mining companies which he identified as overpriced. Neilson believes that fund's success is due to the quality research that avoids “noisy” public information (Boyd, 2009).

Most of the success in active management is a result of momentum investment strategy that takes long positions on securities which is believed to continue to rise in price and short positions in securities which it is expect to have a downtrend (Chen et al., 2000). Fund managers are knowledgeable to use sophisticated software programs that enables them to perform more precise risk analysis and to enhance their stock picking skills (Barber and Odean, 2008). The same paper suggests that in contrast to regular investors, fund managers are less prone to biases that affect decision making meaning also that they are not attention driven. Cici (2005) suggests that managers get aware of their gains less readily than the case of losses. Quite the opposite, investors do not exhibit any stock picking skills and there is evidence that in total the stocks they buy underperform those they sell (Odean, 1999).

2.2. Managers' persistence

On the other hand, a popular fund like the Long Term Capital Management Fund is an example that concentrated brainstorming power does not necessarily mean that abnormal returns even though achieved, can persist. Little academic evidence is supporting the outperformance of active fund managers. Wermer (2000) backs the momentum strategy. More specifically, his research shows that fund managers can beat the market by 1.3% annually only without accounting for trading costs. However, including the trading costs there is an underperformance of 1% annually. Carhart (1997) observed the performance of equity funds and examined whether funds that have done well will continue to have the same performance in the next period as a result of managers' skills. His study provides evidences that funds' performance does not reflect managers' picking skills and concludes that “investment costs account for almost all of the important predictability in mutual fund returns” (Carhart, 1997, pp. 81). The same paper gives valuable guidelines for investing in funds. According to its findings, investors should be aware that no load funds always outperform load funds and should avoid managers who often rebalance their portfolio since portfolio turnover reduces the fund's performance. Moreover, Bodie et al. (2008) indicate that high portfolio turnover rate can also be tax inefficient. Regarding the momentum strategy, Carhart characteristically claims that some funds can earn higher returns the following year due to pure luck of holding large positions in last years' “winners”. Finally, Chen et al. (2000) suggest that the evidence of persistence concerning past winners over past losers is weak.

3. Irrationality

Statman illustrates irrationality by comparing traditional and behavioural finance approaches: “people are rational in standard finance; they are normal in behavioural finance. Rational people care about utilitarian characteristics but not value-expressive ones, and never confused by cognitive errors, have perfect self-control, are always risk averse, and are never averse to regret. Normal people do not obediently follow that pattern” (Statman, 1999, pp. 26). It is clear according to the academic evidence that active mangers provide little or no economic value to investors. Surprisingly however mutual fund industry continues to attract more investors, managing around 1.72 trillion dollars (HedgeFund Intelligence, 2009). What are the drivers of such irrationality?

3.1 Investors' characteristics

Acknowledging their own imperfections is one of the key reasons why investors rely on fund managers. Simon (1978) states that investors present imperfect control and bounded rationality over the uncertain and continuous changing market environment and make final decisions as a result of judgemental errors. Investors are not capable to handle efficiently enormous load of information. Walker (1971) argues that each investor has a certain capacity and upper limit of accumulating information, after which all new information is completely ignored. This indicates that decisions are drawn randomly in an irrational way. Overloaded with information, they tend to follow the financial media that direct their choices.

3.2. Advertising

Advertising seems to work. Investors irrationally focus on advertisements since it appears that funds that have been advertised have more liquidity and attract more individual investors (Jain and Wu, 2000). The media often names fund managers as “the new masters of the universe” which can result in investors believing that superior investing abilities can be achieved through fund managers (Mackintosh, 2007).

Mullainathan et al. (2008) examined the logic behind the success of mutual fund industry in a situation where industry adds little to investors' wealth and charges them high. Their research showed evidence that individuals “think coarsely”; more concrete investors that tend to categorize situations according to their own beliefs and use same conclusions for each category. They evidence significant influence of persuasion and advertising on coarse-thinking. Using data of all financial advertisements in “Business Week” (BW) and “Money” they find out that after the market crash, past return data vanish from advertisements, as shown in figure 1. Moreover, in spite of this selective data approach, in downturn market even funds with good performance choose not to advertise themselves. This finding is in line with their model's predictions meaning that enclosure of past return data is used in purpose of selling opportunities, rather than promoting professional advice services or skills.

3.3. The role of biases and heuristics

The attention grabbing events are often able to drive investors' interest and affect their investment decision. Barber and Odean (2008) name such events: any unusually large trading volumes, prior day movements to the stock price or certain media news. Taffler (2002) suggests that the availability heuristic and the familiarity bias are to be blame for noise trading. The representative heuristic works in accordance to the existence of stereotypes. Investors tend to believe that a good company can be a good investment. Accordingly a good manager can generate great returns. Decisions based on gut feelings are due to the affect heuristic. Concerning biases, investors exhibit behaviour that can be explained on the framework of framing judgemental biases and confirmation biases (Taffler 2002). As for the first, their judgements are based on the way information is presented. As for the second investors will seek for confirming evidence to support their decisions and will neglect any opposing argument.

Despite mutual fund managers' advanced or not investment characteristics, Taffler (2002) suggested that fund managers are also prone to similar cognitive errors, biases and heuristics with investors. More often is the case for fund managers being overconfident and overoptimistic to believe that they have “superior investing abilities”.


Stock valuation and investment decisions are difficult tasks to be actualized with success. Primarily, financial markets are complex and uncertain, continuously change and are affected by multiple variables. Secondly, investors prove to behave in an irrational manner using mental shortcuts and are subjected to various biases. Investing is often directed by the financial media or relied to fund managers that are supposed to have a more rational behaviour. Our report provides evidence that although investors might have reason to believe fund managers, the actual performance of the latter cannot yield returns that could beat the market by accounting for all costs in a consistent basis. It is therefore the investors' characteristics that lead to have such a rationale and at a lower degree any external factors like the press and advertisements.

Assignment - Topic 2

Summarise and critically discuss the empirical findings of “post earnings announcement drift”anomaly in international level.

1. Introduction

The systematic post announcement drifts in returns of stocks are associated with unexpected earnings changes. Since Ball and Brown (1968) first identified the post earnings announcement drift (PAD), many other empirical studies have tested the phenomenon. These studies showed that PAD has international dimension as it is documented in many national stock markets. A crucial article from Fama (1998), although insists that efficient market hypothesis is valid, it admits that the PAD can challenge the Efficient Market Hypothesis (EMH). Mendenhall (2004) claims that there are three main explanations for PAD. Firstly, the unexpected earnings changes could derive from different research methods which are employed. The second explanation is that the PAD results from the systematic wrong market expectation and estimation of future expected return after the earnings announcement. The behavioural explanation is the most common one. Bernard and Thomas (1989), Rangan and Sloan (1998) and Brown and Han (2000) suggest that PAD results from the market inefficiency and irrationality of investors. However, none of the aforementioned explanations can perfectly predict why the market does not react to the public information such as earnings announcement in an accurate and timely way. Our paper seeks to summarize the empirical findings of PAD from different national stock markets.

2. What is the Post Earnings Announcement Drift

Most studies observe PAD in three phases in order to be obtained a closer understanding of the phenomenon. Initially, stock prices adjust to a new level upon an earnings announcement. In the following phase prices begin to drift relative to the market for a period of approximately sixty trading days after the earnings announcement. Last but not least, there is another significant adjustment to stock price around the next announcement of the following quarter's earnings. Thus, as Bernard and Thomas (1989) suggested, PAD could be explained by a delay in a portion of price toward new information.

The research papers of Bernard and Thomas (1990) and Lev and Ohlson (1982) conclude that the PAD is incompatible with the Capital Asset Pricing Model (CAPM). The reason is that the drift is far away from the one CAPM can price. If the CAPM is a correct way to price stocks mechanistically, such a drift is impossible for CAPM to predict. The papers also provide evidence that the PAD is incompatible with the EMH.

3. Methodology of PAD

The traditional methodology of capturing the PAD can be summarized as follows. The portfolios used are formed based on the magnitude and direction of earnings surprises for quarterly earnings announcements. Then, actual market prices of stocks are compared to prices derived from a normative model. The difference of the two prices is reported due to the divergence. The portfolios which have positive earnings surprises are found to enjoy a positive drift above the normatively predicted price, while the portfolios with negative surprises have negative drift below the predicted price. The degree of drift is found to be monotonically positive for increasing positive earnings surprise portfolios and monotonically negative for increasing negative earnings surprise portfolios.

4. Research in International Level

4.1.The Spanish Market

Forner and Sanabria (2008) analyze whether PAD exists in Spanish stock market with a study on 172 firms quoted from Spanish stock market from 1992 to 2003. In the paper, there are some unconditional adjustments to the CAPM and the Fama and French three factor model by adding a liquidity factor to control the portfolios by size and book to market ratios and control for the momentum effect. Based on the sample data, Forner and Sanabria used two earnings surprise measures SUE and REV in order to test the existence of PAD. The research results showed that in the Spanish market, PAD strategy yields significant positive returns in the months after earnings announcements both measures, SUE and REV. Furthermore, PAD is tested to be robust to Jegadeesh's (1993) momentum effect, which means that PAD contributes to the explanatory power of momentum. The results indicate great robustness of PAD and difficulty to have a risk-based explanation which is consistent with EMH. In addition they suggest that the PAD phenomenon is most probable due to an explanation of investors' under reacting or overreacting to the earnings announcements and such a behaviour might be directed from various psychological biases. The paper agrees with Fisher (2001) and Bloomfield (2000) findings that PAD is a result from investors' overconfidence in private information.

4.2. Finnish and Swiss Market

Kallunki (1996) investigated the reaction of the stock market to earnings announcement. The paper uses a risk estimation method with a sample of Finnish companies to show that the reaction delays in the market are different towards the negative unexpected earnings and the positive ones. The reason for that could be caused by the incorrect measurement of the abnormal returns. Geoffrey, Pekka and Martikainen's (2006) research focuses on the non-institutional trading concerning the PAD anomaly. It uses data from the Helsinki Stock Exchange from 1996 to 2000. The paper evidences that there is a positive relationship between extreme positive earnings news and the post-earnings returns. Also the extremely negative earnings returns are related to the PAD. Isakov et al. (2005) uses both theoretical and empirical analysis on the Swiss market to investigate the implied standard deviation (ISD) around earnings announcement dates. The paper claimed that the deviation should decrease after an earnings announcement but the moving path of the deviation depends on the news is bad or good. Lakshmanan (2007) argues that in terms of the post-earnings-announcement-drift anomaly, the unexpected cash flow has a more positive correlation with future returns than with unexpected accruals. Moreover, they also argue that if a company's announcement is decomposed into several parts, it will remarkably outperform other companies that publish their news all at once, which obviously supports the theory that PAD is caused by under reaction.

4.3. Hong Kong Market

Zhao's (2008) focused on the proportional distribution of price reactions on the announcement date and the subsequent price movements since it suggests being an important reason to explain and analyze PAD. Within the sample of Hong Kong stock market dated from 1987 to 2006, Zhao provided additional evidence to enhance the robustness and generality of SUE by establishing the PAD anomaly on the Hong Kong stock market. Furthermore, the study claims that it should be putted a greater emphasis on the adverse share price responses to earnings, due to the fact that the phenomenon largely undermines the explanation of previous researches which conclude that PAD results from market under reaction to earnings surprise. Zhao's research also indicates that non-earnings information has important information content for the instant announcement price reactions and subsequent price movements. Additionally the findings suggest that the hedging strategies produced by non-earnings information can provide significant and long-term abnormal returns. Therefore significant corroboration effect between earnings and non-earnings information is found for the Hong Kong stock market.

4.4. US Market

Pope (1996) argues that the abnormal returns after an earnings announcement is caused by the market inefficiency. The paper suggest that there is a correlation between the magnitude of the PAD and the bid-ask spread. Bernard and Thomas (1989) described that there is an abnormal annualized return of 18% which tend to persist for at least half a year and that stock prices will reflect an expectation that future earnings will be equal to the earnings in last year's quarter. This means that people are overconfidence about their estimate information which leads to the phenomenon of PAD. The paper also suggests that transaction and information processing costs may delay the reaction to earning news. Sadka (2005) worked over the components of liquidity risk and suggested that a large part of PAD returns can be viewed as risk premium for the unexpected variations in the aggregate ratio of informed traders to noise traders. Garfinkel and Sokobin's (2008) paper suggested that PAD has a highly positive correlation with the component of volume that is unexplained by prior trading activity where the unexplained volume represents an indicator of opinion divergence among investors.

5. Conclusion

The review of aforementioned research papers shows that PDA as the robust phenomenon exists in both mature stock markets such as US and Europe and emerging markets such as Hong Kong and China. Most researchers focus on two aspects. There is a focus on the misinterpretation of the implications of current earnings for future earnings. Investors do not posses predictive power to future abnormal returns based on earnings announcement, and have no understanding that random walk is a key characteristic of earnings return. A delayed response of investors due to transaction costs also contribute to the PAD. The other focus is on the behavioural finance where most researchers conclude that PAD results from two kinds of mental deviation of investors. The first is overconfidence and the second is self attribution that both lead in overreaction or under reaction to stock markets. Because of overconfidence and attribution, investors will rather prefer their own so called private information than public information, such as earnings announcement.

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