Summary:
Mutual funds are one of the most attractive investment options for institutional investors in China; thus, understanding the behaviors of mutual funds is crucial for making institutional investments and selecting superior mutual funds. Stock is an important underlying asset for mutual funds, especially equity mutual funds. Furthermore, stock returns are driven by a series of firm characteristics or anomaly factors, and a burgeoning number of factors worldwide provide new investment directions for mutual funds. Institutional investors, including mutual funds, have the motivation and capability to exploit market anomalies. The following questions thereby arise: Do mutual funds exploit market anomalies in Chinese stock markets？ If so, can we select mutual funds based on such exploitation behaviors？ However, the literature mainly focuses on the exploitation of a single market anomaly or single class of market anomalies, and no systematic examination of the hundreds of existing anomalies exists. Moreover, some studies provide contradictory answers to the question of whether institutional investors exploit market anomalies. In addition, most studies are based on the US stock markets, and their findings may not apply to Chinese stock markets. Unfortunately, no such research exists on Chinese capital markets. Thus, this paper seeks to answer the following four research questions: (1) Do Chinese mutual funds exploit stock market anomalies？ (2) If so, can we propose new indicators for mutual fund selection based on their holding stocks and corresponding anomaly factors？ (3) Is the exploitation of stock market anomalies a reflection of fund managers' investment management capabilities？ (4) What are the economic consequences and market impacts of exploiting these anomalies？ To answer these questions, we construct an anomaly score (or A-Score) based on 87 anomaly variables from the Chinese A-share market. To avoid look-ahead bias, we directly adopt the factors from the study by Li et al. (2019). Based on fund holding data and A-Scores of stocks, we further construct the Anomaly Investing Measure (AIM) of mutual funds, which is calculated as the weighted average of holding stocks' A-Score deciles over the whole market universe. A higher AIM indicates that the funds tend to hold stocks with long positions, aggregating the 87 anomaly variables. Based on actively managed equity mutual funds from 2005 to 2019, we first examine whether mutual funds exploit market anomalies in Chinese stock markets. Our empirical results confirm that funds actively allocate more weight to stocks with high A-Scores as compared with the CSI 300 index and historical holdings and that trading behaviors persist for a long time. Thus, Chinese mutual funds do exploit market anomalies. We next examine the relationship between AIM and the cross-section of mutual fund returns. Results regarding both portfolio sorts and regression show that the AIM significantly predicts future returns; moreover, the AIM can be used to select superior funds. Furthermore, we decompose the fund managers' investment abilities and explore the AIM return sources. The results show that funds with a higher AIM exhibit excellent stock selection, style selection, and risk control ability. Finally, we explore the economic impacts of exploiting anomalies at the fund and market levels. Exploiting anomalies not only ensures long-term fund flows but also alleviates market mispricing. Our study makes the following contributions to the literature. First, to the best of our knowledge, our paper is the first to systematically examine whether Chinese mutual funds exploit Chinese A-share market anomalies. Contrary to the literature that focuses on a single factor or single class of factors, our paper provides a new perspective on the investment behaviors of Chinese institutional investors by examining 87 market anomalies. Second, based on the stock market anomaly factors, we propose the AIM, which can be used to select superior mutual funds. Our findings enrich the literature on the return prediction of Chinese mutual funds and provide theoretical support for the development of fund-of-funds in China. Third, this paper explores fund managers' investments in stock anomalies from the logic of fund selection of underlying assets and confirms that anomaly exploitation reflects fund managers' superior stock selection, style selection, and risk control abilities. Thus, our study provides a reliable explanation concerning fund managers' investment skills. Fourth, we find that mutual funds' exploitation of market anomalies could reduce arbitrage returns and mitigate mispricing in the Chinese A-share market. Thus, our study enriches the literature on mispricing in the Chinese market and helps understand institutional investors' behaviors from a new perspective.
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