Chapter 2.Literature Review & Hypothesis
B. Herding Behavior
a. Herding theoretical researches
There are three main herding theories explaining why fund managers herd in the financial market. We put all related researches in order as follows.
First, reputation-related herding: Scharfstein and Stein (1990) and Zwiebel (1995) also propose that since fund managers undertake the reputation concerns, they tend to discard their private information and decide to follow the benchmark to easily get evaluated. However, Zwiebel (1995) present different model to examine how a leader manager leads other managers to herd, while Scharfstein and Stein (1990) examine the effect of “sharing the blame” effect which point out how fund managers act like followers. Furthermore, Graham (1999) reveals that herding behaviors can happens among non-private investment information. Graham (1999) extends the model and produces relevant evidence that with high reputation or low ability concerns, fund managers herd with “Value Line.”
Second, information cascade herding: Banerjee (1992), Bikchandani, Hirshleifer, and Welch (1992) and Welch (1992) all reveals that latter fund managers tend to discard their private information and learn investment decision-making strategies from previous fund managers who are thought to be well-informed. This will incur subsequent mimic investment behaviors called “informational cascade.” Banerjee (1992) provides models of herding behavior as cascades. Bikchandani, Hirshleifer, and Welch (1992) further provide the fragility of cascades with all types of shocks. Welch (1992) provides the similar concepts in stock market for initial public stock offerings.
Third, similar information cluster herding: Froot, Scharfstein and Stein (1992), Hirshleifer, Subrahmanyam, and Titman (1994), and Barberis and Shleifer (2003) reveal that under inefficient market, part of fund managers receive common private information together before others do, they tend to herd. Because they follow the same
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sources of private information. Barberis and Shleifer (2003) further propose a new category investment to examine whether the same sources of private information bring profits. Overall, Devenow and Welch (1996) provide theoretical herding researches in review.
b. Herding empirical researches
Despite there are strong theoretical researches of herding behaviors, empirical evidences of herding behaviors also take into deep examination. Lakonishok, Shleifer, and Vishny (we call LSV hereafter) (1992) use holdings of 769 US tax-exempt funds (mostly are pension funds) to evaluate the effects on stock prices. The data is quarterly ownership of shares, and the examined period is positioned from 1985 to 1989. They find that small stocks have more apparent herding and positive-feedback trading than largest stocks. Wermers (1999) further modifies LSV herding measuring model to examine the strength of “buy herding” and “sell herding.” In this research, Wermers (1999) examine all categories of mutual funds to analyze herding behaviors, with data period from 1975 to 1994. The evidence shows that small stocks and growth-oriented funds find out have higher level of herding behaviors. Besides, Wermers (1999) also find that evidences of herding behaviors in growth-oriented funds respect to “positive-feedback strategy,” that is ,buy herding is strongly related with high past-return stocks;
sell herding is strongly related with low past-return stocks. On the other hand, Grinblatt, Titman, and Wermers (1995) modify LSV model and provide “Momentum measure” to investigate how “positive-feedback strategy” work in mutual funds. They find that 77percent of mutual funds act as momentum investors who buy high past returns more than sell low past returns. Besides, they also find that performances of funds positively correlated with momentum. There are considerable empirical researches in herding behavior later developed. Bikhchandani and Sharma (2001) and provide a
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comprehensive empirical survey of related herding behaviors researches in financial markets. Massa (2005) empirically demonstrates that how compensation incentives offset herding behavior, performance persistence in mutual funds and how a gap between compensation and reputation incentive can be bridged by family affiliations.
Boyson (2005 & 2010) demonstrates evidence that even for hedge fund managers, they would act the same ways as mutual fund managers since they also have to concern about the fear of fund failure and desire to attract new customers.
c. Taiwan herding related literatures
There are plenty of researches of herding behaviors in Taiwan mutual fund market.
Si-In Li (2006) and Chieh-Yuan Wu (2013) further extends binomial distribution (LSV model) to trinomial distribution for measuring herding behaviors. This model consider buy side, sell side and holding strategy. Si-In Li (2006) finds LSV model might overrate herding behaviors of fund managers. On the other hand, Chieh-Yuan Wu (2013) further investigates factors that influence herding behaviors of fund managers, including emotions of managers, corporate size and PDR.
Chun-Han Chao (2010) further takes risk aversion of investors into consideration, investigating in what kind of market condition investors emphasize relative benchmark and then affect herding behaviors of fund managers.
Ching-mann Huang (2005) provides that scale effect will enlarge compensations of fund managers after first-term well-performed performance. Besides, the research also reveals the how differences of abilities affect herding behaviors of fund managers; to what extent, mental accounts will lead fund managers discard private information.
Chia-Hsuan Chiu (2008) investigates how relative performance affects investment decision of mutual fund investors. Moreover, Chia-Hsuan Chiu (2008) also provides new perspectives on herding behavior of mutual fund managers in terms of investors
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and contractual incentives. The research reveals that in long evaluation term, investors who emphasize relative performance more induce the tendency to herd for fund managers. However, high-incentive contracts are not significantly related low herding behaviors of fund managers in this research.
Chih-Chieh Chen (2013)investigates the relationship between fund characteristics, fund managers’ attributes and herding behaviors. He samples 105 opened-equity mutual funds and the period contains from 2008 to 2012. Chih-Chieh Chen (2013) finds only degree and certificate of college significantly related to herding behaviors. On the other hand, fund scale, fund age, redemption rate and commissions for fund managers are significantly related to herding behaviors except purchase rate.
Fu and Lin (2009) reveals that fund size, fund age and performance affect herding behaviors. Amid of them, small-sized funds tend to herd more than large-sized funds;
low performance funds tend to herd more than high performance funds; younger funds tend to herd more than older funds. On the other hand, Fu and Lin (2009) also find that up market condition induce funds take herding more than in low market condition.
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2-2 Hypothesis development
We know that the management structure of mutual fund companies is delegated portfolio management relationship, that is, some investors who neither have much information nor are knowledgeable enough to make a profitable investment decision need professional investment recommendations to help those investors earn the profit. Therefore, fund managers are expected to be professional and have high ability to choose profitable portfolio which help investors earn the profit. However, there are agency problems resulted from this sort of delegated portfolio management relationship. Under the 1940 Investment Company Act regulations, investors are allowed to monitor mutual fund companies, and fund managers are allowed to only possess the performance fee charged to fund companies.1 Besides, fund companies cannot design compensation incentive contracts that motivate fund managers to make undesirable investing behavior to hurt the benefits of investors (Modigliani and Pogue,1975；Chevalier and Ellision, 1999). Modigliani and Pogue (1975) reveal that under explicit compensation schemes of fund companies, there are alternative investment performance fee arrangements to affect fund managers investment decision-making behavior. It leads fund managers to act and derive from average and attract new inflows. However, it will induce capital market inefficiency and arise severe agency problem between investors and mutual fund companies. Subsequently, Fama (1980), Lazear and Rosen (1981), Holmstrom (1999) note that fund managers may have career concerns to alleviate agency problem.
Chevalier and Ellison (1999) show the career concerns have different effect when they take the tenures of fund managers into consideration. Chevalier and Ellison (1999) explore the implicit inventive induced from career concerns which make fund managers, especially
1 Investment Advisers Act of 1940 and General Rules and Regulations Thereunder. Securities and Exchange Commission, Washington, D.C., April 1, 1971.
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younger ones, take herding behavior to avoid fund termination. That is, younger fund managers are concerned about their job-loss in the future and therefore they will take more conventional decision-making to save their job. The following literatures similarly focus on whether career concerns lead to herding behavior among fund managers (Scharfstein and Stein 1990; Zwiebel 1995; Prendergast and Stole 1996; Morris 1997;Avery and Chevalier 1999；Graham 1999).
On the other hand, Scharfstein and Stein (1990) demonstrate that “…managers will be more favorably evaluated if they follow the decisions of others than if they behave in a contrarian fashion. Thus an unprofitable decision is not as bad for reputation when others make the same mistake. They can share the blame if there are systematically unpredictable shocks.” This is what Scharfstein and Stein (1990) call “sharing-the-blame” effect. In other word, we can see fund managers are inclined to make the same decisions (herding) as other fund managers to deter from laid-off even they hold private information in hand. We here expect this “sharing-the-blame” effect will induce herding in the bear market, where systematically unpredictable shocks are much more, since in bear market fund managers have stronger career concerns.
From above literature, we find that career incentive lead fund managers to discard their private information to herd for the decrease in possibility of laid-off, even these private information may realize high expected returns in the future (Scharfstein and Stein, 1990).
The reasons that mutual fund tends to discard these private information and herd are related to typical delegated portfolio management relationship. Goldman and Sleazak (2003) show that under circumstances of high mobility and turnover rate of fund managers, they will discard long term information since these investment period investor can be terminated at a very short notice. Chevalier and Ellison (1999) show that “fund termination” mostly happen more to younger fund managers who have career concerns to preserve jobs than to
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older ones. Hence, these younger fund managers have inclinations to deter from possessing fund portfolio of idiosyncratic risk level or weight of specific fund sectors deviates considerably from average funds’ peer group because they cannot bear the loss of reputation.
Therefore, Froot, Scharfstein, and Stein (1992) reveal that fund managers, especially those younger ones face short-term trading, have less incentive to wait until their long-term information is revealed and incorporated in expected stocks prices maximization.
We know that the fund managers tenures take an effect on decision-making behaviors because these fund managers possess career concerns of being laid off. Therefore, we here use negative market returns as proxy of career concerns incentives to examine the relationship between fund managers’ tenures and herding behaviors. The reason why we use negative market returns as proxy of career concerns are presented in Since Khorana (1996) and Hu, Hall, and Harvey (2000). They reveal that there is an inverse relationship between fund managers replacement and past performance, i.e., fund managers with poor past performance face highly-risk turnover rate. Chevalier and Ellision (1999) also show in the research, fund managers have poor past performance lead to fund outflows and therefore being replaced. This situation is more likely to happen in bear market, which negative returns usually happen. Chevalier and Ellison (1999) show that job loss indeed more likely happens after bear markets than after bull markets. Karceski (2002) also reveals that in bear markets, fund managers only care about their job, not their outperformance comparative to other fund managers, i.e., career concerns are strong in bear market, but in contrast, compensation concerns are weak in bear market. Zhao (2005) points out low probability of fund termination brings low unemployment for fund managers. Therefore, they are not worried to be laid off in bull market.
Hence, we here predict that, when career concerns dominates on the market, fund managers with shorter tenures tend to herd to prevent from replacement.
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Hypothesis 1:
When career concerns dominate on the market, fund managers with shorter tenures would rather to herd than not to herd.On the other hand, a strategic literature review from Roberts (1999) examines the product innovation ensures sustained high profitability and therefore, companies can maintain high performance position. However, as time elapses, there are more imitators want to follow the strategy provided by first mover, as a result, the market competition of new product increase and decrease the profitability of new products.
Therefore, we find out if a particular fund is a first mover, it will take the lead and induce market competition gradually. The first mover will maintain its position and keep high profitability but some other follower will show and imitate the first mover. According to past literature of informational cascade herding, we find out fund herding is mainly because of informational prevalence and thus induce herding if this information reveals well-performed outcome. Friend et al. (1970) found, during a quarter in 1968, a tendency for mutual funds follow the investment decisions made in the previous quarter by successful and better performance funds. Grinblatt et al. (1995) find that most stock mutual funds purchased past winners during 1974–84. They find a tendency for funds to buy and sell stocks at the same time in stocks in which a large number of funds are active.
Sushil Bikhchandani, David Hirshleifer and Ivo WelchSource (1998) reveal that the theory of informational cascades theory suggests that firms should imitate each other in their product decisions. From the research of Kennedy (1997), among ABC CBS and NBC,
"the networks tend to make introductions in the same categories as their rivals (e.g., situation comedies, medical dramas, adventure series)."
We here want to combine market competition and informational cascade evidence in mutual fund industry. We predict that as time elapses, when specific fund’s market competition becomes fierce, it means this fund becomes a follower. It will trace
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informational cascade which is induced from first mover and take herding to obtain the profit.
Hypothesis 2: When specific fund’s market competition becomes fiercer as time
elapse, it becomes a follower to herd because of informational cascade.14