Idiosyncratic Risk, Fund Returns and Fund Flows

A number of recent studies have examined the impact of equity fund idiosyncratic risk on the ability of investors to judge mutual fund manager performance. In this article we summarize the results of these studies, with an emphasis on the effect of idiosyncratic risk on fund returns and fund flows.

The studies show, not surprisingly, that equity mutual funds tend to be undiversified, with their performance driven by some level of unsystematic volatility (idiosyncratic risk), systematic volatility, and their managers’ stock picking skills. As the idiosyncratic risk of a fund increases, that fund’s returns begin to cluster in the tails of the return distribution.  This behavior can lead to a “false discovery” on the part of investors because idiosyncratic risk (at all but the lowest levels) makes it impossible to judge the true skills of fund managers.

In regard to the clustering of returns in the tails, funds with the highest idiosyncratic risk are the most likely to jump from one tail of the performance distribution to the other; approximately 32% of the funds with the highest idiosyncratic volatility oscillate between the two tails from one year to the next. This movement suggests that even those managers who are skilled stock pickers can be buried in their performance quintile or quartile by those lucky managers who pull up the extreme right tail of the distribution. These lucky managers with high idiosyncratic volatility can produce positive performance even if they are not highly skilled in stock selection. And if funds are ranked just on a performance basis, the lucky managers’ allocation to performance portfolios is driven largely by idiosyncratic noise. This noise then, with its twin features of “false discovery” and tail swings, constitutes an important factor in understanding why investors seem to increasingly tolerate the existence of underperforming fund managers.

Other authors have looked at the effect of idiosyncratic risk on fund flows. These studies show there is a convex relationship between performance and flows. (We use convex in the sense that flows into the top-performing funds are disproportionally more sensitive to relative performance than are flows out of the funds that inhabit the bottom third of the performance distribution.) When funds’ idiosyncratic risk increases, fund flows become progressively less responsive to the funds’ good or bad performance. One study showed that highly idiosyncratic funds have 67% less sensitivity to the flows-performance relationship than do low-idiosyncratic funds. In other words, if investors use performance primarily to infer managerial skills and if fund performance is mostly driven by noise, the flow-performance sensitivity diminishes because of the greater uncertainty surrounding the performance. In particular, it has been shown that investors become progressively less sensitive to performance for those funds engaging in more idiosyncratic risk taking. [1]