FALL 2007
VOL. 8 NO. 2


It might seem like a safe bet to mimic the trading strategy of mutual funds. But Russ Wermers, associate professor of finance, cautions investors to be wary of blindly following the herd. Wermers, with Nerissa Brown, PhD '05, University of Southern California, and Kelsey Wei, University of Texas at Dallas, is coauthor of "Analyst Recommendations, Mutual Fund Herding and Overreaction in Stock Prices," a paper that documents the tendency of mutual fund managers to follow analyst recommendation revisions when they trade stocks and the impact of such mutual fund "herding" on stock prices. Herding is the tendency of funds to buy or sell the same stocks during the same calendar quarter, more than would be expected by random chance.

The authors analyzed quarterly stock trades by U.S. equity mutual funds following the recommendation revisions of sell-side analysts across all U.S. stocks from 1994 to 2003. When examining revision changes and herding activities, they observed that when analysts revised stocks upward, the mutual funds tended to respond by buying in herds, and when stocks were revised downward, funds tended to respond by selling in herds. The stocks bought by herds had an initial increase in price, but after about six months, the prices of those stocks went into a reversal and dropped sharply. Stocks sold by herds experienced exactly the opposite pattern-first they went down in price, but then they rose again.

This indicated to Brown, Wei, and Wermers that mutual fund managers are overreacting to the recommendations of analysts. "This is the first time that anyone has found solid evidence, on a widespread scale, that any type of asset managers destabilize markets through their trades, actually pushing prices around and away from the fundamental prices of the shares," says Wermers.

Wermers has looked at the way mutual funds affected the market before, in research covering fund trading from 1975 to 1994 and published in the Journal of Finance in 1999. At the time, he found that mutual funds acted as a stabilizing force, driving stocks toward a fair price. Now mutual fund managers are destabilizing the market. So what has changed? Part of the answer may be that there are so many more mutual funds now. In 1994, mutual funds held 13 percent of all equities. In 2005, they held 22 percent, about double the share of ownership of the entire stock market. Mutual funds also trade more, partly because trading costs have dropped significantly. So, it is likely that far in excess of 22 percent of trading activity can be attributed to mutual funds.

The authors worried that perhaps analysts and mutual funds might simply be responding to the same external signals, such as a change in the stock risk, earnings news, or past returns, and funds might not be watching the analysts at all. But, after controlling for such common external influences, they found that mutual fund herding was still strongly linked to analyst recommendations.

The professors also found that mutual funds that did poorly over the past year were more likely to herd on analysts' signals, perhaps because managers of losing funds are already at risk of losing their jobs and, thus more likely to seek the safety of investing with the crowd. That way, if they continue to perform poorly, at least they will not stand out. "They seem to say to themselves 'How can I stay safe,'" says Wermers. "Winning funds see an analyst's recommendation and take a more thoughtful approach, perhaps because they're less worried about their reputations and have a little more breathing room."

This almost seems to argue for a contrarian investing strategy - watch what the majority of mutual fund managers do, and then do the opposite. But Wermers cautions that individual investors should not take on such a strategy without considering the substantial risks involved: with many stocks, the reversal pattern did not hold, and investors could lose a great deal of money trying to profit on it.

For more information about this research, contact rwermers@rhsmith.umd.edu.