Corporate managers, price noise and the investment factor

This study investigates the impact of flows between bond and equity funds on investment factors over the period 1984-2015. It determines contemporaneous mispricing effects and a statistical reversal relation between these flows and both legs of the investment factor. The statistical reversal relationship between previous flows and the investment factor is economically significant. A one-standard-deviation shock to flows causes a 0.29% decrease in investment factor returns, which are reversed within 5 months. A trading strategy based on signals from past flows and the investment factor outperforms the market by 0.68% in the months following positive flows and produces significant alphas after accounting for well-known equity risk factors. The findings are interpreted as evidence in favor of a behavioral explanation, in which sentiment influences actual managerial decisions. When retail investors and managers are swept up in market euphoria, retail investors shift their holdings from bond to equity mutual funds, and high-investment firms invest more aggressively. Market-level euphoria has a different impact on high- and low-investment firms, and thus the investment factor can be influenced. Hence, the mispricing occurs during these periods, and the reversal relationship is especially pronounced for a high-investment portfolio versus a low-investment portfolio. As a result, during the months following periods of positive flows, the investment factor outperforms the market factor. Interestingly, this study's measure of flows, which serves as a proxy for market-level euphoria, outperforms other measures of investor sentiment.