Sustainability ratings do not change the disposition effect of Indian equity fund managers but redemption pressure does
This study of Indian equity mutual funds from 2013 to 2024 finds that while sustainability ratings do not influence the disposition effect, redemption pressure significantly drives managers to realize gains over losses, suggesting the phenomenon stems from structural constraints rather than cognitive bias.
Original paper licensed under CC BY 4.0 (https://creativecommons.org/licenses/by/4.0/). This is an AI-generated explanation of the paper below. It is not written or endorsed by the authors. For technical accuracy, refer to the original paper. Read full disclaimer
In the world of investing, there is a well-known human tendency called the disposition effect. It describes a common psychological habit where people sell their winning investments too quickly to lock in a feeling of success, while holding onto their losing investments for too long, hoping they will eventually recover. This behavior is often seen in individual investors, driven by the emotional pain of admitting a loss. But a different question has long puzzled experts: do professional fund managers, who are paid to be rational and disciplined, fall into the same trap? Or is what looks like a psychological bias actually something else entirely? In the fast-growing market of India, where millions of people invest through mutual funds, researchers set out to determine if these managers are acting on instinct or if they are simply reacting to external pressure. The answer matters because it changes who is responsible for how money is moved: is it the individual manager's mind that needs fixing, or is it the structure of the fund itself that forces their hand?
A team of researchers from several Indian universities decided to investigate this by looking at the actual trading records of 372 equity mutual funds over a twelve-year period, from 2013 to 2024. They examined monthly snapshots of what stocks these funds owned, tracking whether the managers sold stocks that had gone up in value or held onto those that had gone down. Their goal was to see if the pattern of selling winners early and losers late was a consistent habit of the managers, or if it appeared only when specific conditions forced them to act. They focused on two main possibilities. The first was that the managers simply preferred to realize gains, a cognitive bias that would show up regardless of the fund's situation. The second was that the managers were under a "structural straitjacket," a term describing a situation where they are forced to sell their most liquid, profitable stocks to raise cash because investors are withdrawing their money.
The study found that Indian fund managers do indeed show the disposition effect. On average, they sold winning stocks at a higher rate than losing ones, a pattern that held true in sixty percent of the months they studied. However, when the researchers looked at what caused this behavior, the evidence pointed strongly away from personal psychology and toward external pressure. They discovered that the tendency to sell winners early became significantly stronger in the month immediately following a period where investors withdrew money from the fund. When a fund faced redemptions, the managers were much more likely to sell their profitable holdings to raise the necessary cash. In contrast, general market volatility, or the ups and downs of the stock market itself, did not seem to trigger this behavior. The managers did not sell winners just because the market was shaky; they sold them specifically when they needed to pay back investors.
To understand if this was a trait that managers carried with them from one job to another, the researchers tracked managers who switched between different fund companies or different types of funds within the same company. The data offered suggestive, though not definitive, evidence regarding whether this behavior was a fixed personality trait or a reaction to the job. While managers moving to a new fund appeared to align their trading habits with the new environment, the study noted that the pattern of selling winners had already been declining for two years before the move and continued to fall afterward. This pre-existing trend means the data cannot conclusively prove that the environment reshaped the manager's bias, only that the two moved together. The study also looked at whether managers treated environmentally friendly, or sustainable, stocks differently. They found no significant difference in how these stocks were sold compared to others in terms of the overall level of the effect. However, the researchers explicitly noted that the question of whether redemption pressure affects sustainable holdings differently than others remains unsettled, as the study lacked the statistical power to detect a difference of that specific magnitude.
Ultimately, the research suggests that the behavior often mistaken for a manager's bias is actually a mechanical response to the need for liquidity. When investors pull their money out, managers are forced to sell the easiest-to-sell assets, which are often the ones that have already made a profit. This finding shifts the focus of the problem. If the issue were purely psychological, the solution might involve training managers to overcome their instincts. But since the driver is the flow of money in and out of the fund, the solution lies in how funds are designed and managed. The responsibility for this pattern rests less on the individual manager's mind and more on the structure of the fund, its redemption policies, and how it handles the daily reality of investors coming and going.
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