How Fear Rules the Fund Flock

At T. Rowe Price's annual investment briefing earlier this month, PRGFXGrowth Stock fund manager Robert W. Smith worried aloud about investor short-sightedness, saying, "Individuals must stop renting stocks and start owning stocks again."

Smith said this trader mentality heightened market instability, and his point was well-taken. Then again, so was a question put to Smith by a reporter: "When do you think fund managers will stop renting stocks and start owning them?"

Smith, the subject of a recent 10 Questions, might be the wrong manager to ask -- his fund has topped the market and most of his peers during the past 10 years while keeping expenses, risk and turnover fairly low. But the discussion illustrates a key point: Money managers, far more than often-blamed individual investors and daytraders, deserve the lion's share of the blame for the market volatility of the past several years, because of their "herding" mentality and performance-chasing. And if the past few months are any indication, plenty of money managers are still acting like traders.

Herding

A study in the October Journal of Finance titled "Who Blinks in Volatile Markets: Individuals or Institutions?" concluded that institutions -- mutual funds, in particular -- bear more responsibility for short-term volatility than individuals. The researchers compared stocks that were essentially identical except for institutional ownership levels. On "event days" -- days when the market rose or fell by 2% or more -- stocks with high institutional ownership levels were far more volatile than stocks held largely by individuals. They attribute this to "herding" behavior by fund skippers.

"Institutional managers should be a bit brighter and less subject to biases than individuals," said Patrick J. Dennis, a University of Virginia associate professor and co-author of the study with Deon Strickland of the Securities and Exchange Commission. The study examined stock market volatility over eight years through the end of 1996. Dennis said fund managers are prone to cause more volatility because of a combination of behavioral finance, "asymmetric information" -- in other words, "thinking that the other guy who is buying may have heard something through the grapevine that I haven't" -- and simply the dictates of their job market.