“Mutual fund herding behavior and investment strategies in Chinese stock market”

This investigation studies the impact of mutual fund herding on the returns achieved by contrarian strategy from 1990 to 2015 in the Chinese stock market. The relationship between the profit gained by the contrarian strategy and the macroeconomic environment is also examined. First, the returns of the contrarian strategy in China’s stock market are found to be significant. Second, most loser stocks with a high degree of mutual fund herding outperform loser stocks with a low degree of mutual fund herding, revealing that the profitability of an investment portfolio depends on the degree of mutual fund herding. Third, investors should buy loser stocks with a high degree of herding and sell winner stocks with a low degree of herding during a two-year formation period, over which zero-cost contrarian strategies yield the significantly highest return. Finally, the payoff of contrarian strategies is positively related to the herding effect and negatively related to macroeconomic variables.


INTRODUCTION
1 Kang et al. (2002) found that the short-horizon contrarian strategy yields significantly abnormal profit primarily owing to overreaction to specific information.Chao and Wu (2004) found that the contrarian strategies are one to two years, and that the shorter of contrarian strategies on the Chinese stock market than on in the American stock market is responsible for the high turnover in the Chinese stock market.Hu and Lu (2010) found that a contrarian strategy outperforms a momentum strategy in commodity futures, regardless of the holding period, and that metals futures are the only commodity futures that do not exhibit significant contrarian effects.
Investment strategies, which can be grouped into contrarian and momentum strategies, have been the topic of many financial studies.Investors who follow contrarian strategies buy previous losers and sell previous winners.Contrarian strategies differ from momentum strategies, which involve buying past winners and selling past losers.Contrarian strategies were examined by Bondt and Thaler (1985) who identified an overreaction phenomenon in the market causing past losing stocks to outperform past winning stocks.Contrarian strategies have been validated for the American stock market (Lakonishok et al., 1994) and for A-shares in China's (Kang et al., 2002;Chao & Wu, 2004) stock market.The literature presents contradictory findings concerning period for which a contrarian strategy is successful in China's stock market 1 .Jegadeesh and Titman (1993) proposed the first momentum strategy, which involved buying stocks that had performed well in the past and selling stocks that had performed poorly in the past, yielding a significantly positive return over a one-year holding period.The momentum strategy is valid for the American (Wang & Wu, 2011) and Chinese (Cheema & Nartea, 2014) stock markets.The literature reveals that significant profits can be gained over a short horizon using a contrarian strategy and over an intermediate horizon using the momentum strategy on the American (Yao, 2012) and Chinese (Cheema & Nartea, 2014) stock markets.The literature presents contradictory findings about the validity of contrarian and momentum strategies in the Chinese stock market.This study identifies the most effective of these two prominent stock trading strategies for the Chinese stock market.
The relevant literature presents several findings concerning the behaviors of investors in financial markets.Herding behaviors are very prevalent.Herding behavior is defined as the copying by investors of the behaviors of other investors and the making of similar decisions.(2015) found that the profitability of an investment strategy depends on the degree of herding.Thus, this study evaluates the effect of mutual fund herding on the contrarian strategy in Chinese stock market.
Also, Jegadeesh and Titman (1993) proposed the establishment of zero-cost portfolios based on the momentum strategy.Grinblatt and Moskowitz (1999) constructed zero-cost portfolios using industrial stocks.Subsequently, Demirer et al. (2015) formed a portfolio based on the asymmetric relationship between herding and momentum returns and suggested the implementation of zero-cost portfolios.However, few investigations have considered herding behavior in relation to the use of a contrarian strategy to build zero-cost portfolios2 .To elucidate the economic value of the asymmetric relationship between herding and an investment strategy, this investigation examines the profitability of a zero-cost portfolio which is based on various degrees of herding and a contrarian strategy.
In the Chinese stock market, economic and political changes are important factors in any examination of investment strategies for that market.The literature (Wang et al., 2014) has shown that economic policy uncertainty strongly affects many firms' investment activities.Chordia and Shivakumar (2002) found that the payoffs of momentum strategies can be explained using a set of lagged macroeconomic variables.Stivers and Sun (2010) performed regression analysis to study the effect of herding behavior on the outcomes of momentum strategies.However, few studies have considered the relationships between the returns of contrarian strategy and macroeconomic factors.Owing to the huge effects political changes in China, the relationships between the returns of investment strategy and macroeconomic factors are examined herein.
This study contributes significantly to this field of research and fills a gap in the literature.It uses an intuitive herding measure that was proposed by Lakonishok et al. (1992) and individual stock data to elucidate the effect of investment strategies in the Chinese stock market.This investigation also considers the asymmetric relationship between herding behavior and investment portfolios to construct zero-cost portfolios.This study also analyzes the relations between the profit generated by the contrarian strategy and macroeconomic factors.The findings are as follows.First, unlike the momentum strategy, the contrarian strategy is profitable over a long period in the Chinese stock market.Second, most loser stocks with a high degree of mutual fund herding outperform loser stocks with a low degree of mutual fund herding.Third, a zero-cost portfolio, with a long position in a loser portfolio with high herding and a short position in a winner portfolio with low herding, yields the significantly highest return during a formation period of two years.Fourth, contrarian strategies can be explained by mutual fund herding and macroeconomic factors.
The rest of this study proceeds as follows.Section 1 presents the data and methodology used.Section 2 discusses empirical results, and last section draws conclusions.

Construction of investment strategy
This study investigates the performance of a contrarian strategy with various formation and holding periods of two, four, eight and twelve quarters.Since four formation periods and four holding periods are used, 16 (4×4) contrarian strategies are developed.First, to construct portfolios of winner and loser stocks, stocks are sorted in order of ascending return during the formation period.Based on this sorting, five equally sized quintile portfolios are formed.The quintile portfolio with the highest average stock return is the winner portfolio and that with the lowest average stock return is the loser portfolio.Next, the average return of the winner and loser portfolio in the holding period is calculated, and the difference between the returns of those portfolios is obtained using a t-test.
If the difference between the returns of the loser and winner portfolios in the holding period is significantly positive (negative), then the contrarian (momentum) strategy is regarded as effective.

Herding effect
In the literature (Demirer et al., 2015), the CSSD (Cross-Sectional Standard Deviation) and the AF is the adjustment factor that was defined by Lakonishok et al. (1992).

Effect of herding behavior on the return of contrarian strategy
To measure the impact of mutual fund herding on the return of the contrarian strategy, first, quarterly herding coefficients HM are sorted in as- cending order.Based on the sorting, three equally sized groups are formed.The group with the highest (lowest) herding is defined as the high (low) herding group.Next, the winner portfolios and loser portfolios are sorted by the degree of herding during the formation period and subsequent returns during the holding period are calculated.The t-test is performed to determine the difference between returns of highest and lowest herding on winner or loser portfolios; if the difference is significant, then mutual fund herding is regarded as having an impact on the return of investment strategies.
Based on this asymmetric herding relationship with the investment strategies, we analyze a zerocost contrarian strategy, which involves taking a long position in the loser portfolio while taking a short position in the winner portfolio with a different degree of herding, which is established as the returns of these portfolios during the subsequent holding period are calculated.

Relation between contrarian strategy and macroeconomic variables
To measure the relationship between contrarian strategy and macroeconomic variables, this investigation follows SR is the ac- cumulated lagged three-year return; t ε is the re- sidual, and β are coefficients to be estimated.Stocks are sorted in order of ascending average return over the formation period.Then, five equally sized quintile portfolios are formed.The quintile portfolio with the highest average return is the winner portfolio and that with the lowest average return is the loser portfolio.The average returns of the winner and loser portfolios during the holding period and the difference between the returns of the loser portfolio and the winner portfolio are calculated.The momentum strategy provides significant positive returns with formation and holding periods of two or four quarters.

Descriptive statistics
Table 2 also shows that the contrarian strategy provides a significant positive return, except a formation period of two quarter and the holding periods of two and four quarters.This paper found the highest returns of the contrarian strategies is 0.79 with a formation period of twelve quarter and the holding period of two quarter.This study also shows that the contrarian strategy provides a significant positive return with a formation period of eight or 12 quarters, regardless of the holding period, and with a holding period of eight or twelve quarters, regardless of the formation period.This result reveals that the contrarian strategy is more effective over the long run than the short run.This finding is consistent with that of Chao and Wu (2004) who found that the contrarian strategy was effective over holding periods of one to two years.

Effect of degree of herding portfolios
Table 3 presents empirical evidence concerning the degree of herding on the returns of winner, loser and contrarian strategy in the Chinese stock market.The study defines three groups by herding.The group with the highest (lowest) degree of herding is defined as the high (low) herding group.The winner portfolios and loser portfolios are then sorted by their degree of herding during the formation period, and returns during the subsequent holding period are calculated.No significant difference is found between the returns of winner portfolios with high and low degrees of herding, implying an insignificant spread between winners with high herding and low herd-ing in each period, except with formation (F) and holding (H) periods of (F = 8, H = 2), (F = 8, H = 4), (F = 12, H = 2) and (F = 12, H = 4) quarters.
Loser stock portfolios with high herding significantly outperform loser stock portfolios with low herding over all periods except formation (F) and holding (H) periods of (F = 2, H = 12), (F = 4, H = 12), (F = 8, H = 12), (F = 12, H = 2), (F = 12, H = 4) and (F = 12, H = 12) quarters.Mutual fund herding has an asymmetric effect on loser stock portfolio returns, and the profitability of the investment portfolio depends on the degree of mutual fund herding.This finding is consistent with a previous study (Demirer et al. 2015), which found asymmetry between herding and momentum.

Zero-cost strategies
Table 4 presents empirical evidence concerning return on zero-cost portfolios.To study the economic value of a zero-cost strategy which is based on the asymmetric effect of herding behavior on the return of investment portfolio, this study uses the zero-cost contrarian strategies that involve taking a long position in a loser portfolio with various degrees of herding while simultaneously taking a short position in a winner portfolio with various degrees of herding.
Taking a long position in a loser portfolio with a high degree of herding while taking a short position in a winner portfolio with a high degree of herding yields the significantly highest return over formation (F) and holding (H) periods of (F = 2, H = 4), (F = 2, H = 12), (F = 4, H = 12) and (F = 8, H = 12) quarters.The zero-cost contrarian strategies generate the highest returns when they buy losers with high herding and sell winners with low herding over a formation period of eight quarters and a holding period of two quarters.Overall, this study found the returns of investment strategies with higher herding in their long positions in loser portfolios are significant positive.Note: RFH2 is the spread between the average return of loser and winner stock portfolios during a formation period of two quarters and following a holding period of two quarters; F2H4 is the spread between the average returns of the loser and winner stock portfolios during a formation period of two quarters and following a holding period of four quarters ; F4H2 is the spread between the average return of the loser and winner stock portfolios during a formation period of four quarters and following a holding period of two quarters; F4H4 is the spread between the average return of loser and winner stock portfolios during a formation period of four quarters and following a holding period of four quarters; F8H2 is the spread between the average return of loser and winner stock portfolios during a formation period of eight quarters and following a holding period of two quarters; F8H4 is the spread between the average return of loser and winner stock portfolios during a formation period of eight quarters and following a holding period of four quarters; F12H2 is the spread between the average return of loser and winner stock portfolios during a formation period of 12 quarters and following a holding period of two quarters; F12H4 is the spread between the average return of loser and winner stock portfolios during a formation period of 12 quarters and following a holding period of four quarters.The winner (loser) portfolio of stocks is the quintile portfolio with the highest (lowest) mean stock returns.Mutual funds are sorted into three equally sized groups by herding coefficient, calculated using Eq. ( 1), and the one group with the highest (lowest) herding is defined as the high (low) herding group; *, **, and *** denote significance at the 10%, 5% and 1% levels, respectively.

CONCLUSION
This investigation studies contrarian strategies in the Chinese stock market and the impact of herding behavior on the returns of such strategies.The literature (Demirer et al., 2015) shows the impact of herding behavior on the return of the momentum strategy and discusses the construction of zero-cost portfolios using herding and momentum strategies.This study considers the effect of herding behavior on the returns of contrarian strategies and zero-cost portfolios that are based on asymmetry between herding behavior and the returns of investment portfolios.
First, this investigation finds that a contrarian strategy that involves buying a loser stock portfolio and selling a winner stock portfolio is effective in the Chinese stock market.Second, most loser stocks with a high degree of mutual fund herding outperform those with a low degree of mutual fund herding.The profitability of investment portfolios depends on the degree of mutual fund herding.Third, a zero-cost portfolio that buys loser portfolios with high herding and sells winner portfolios with low herding yield the significantly highest return during a formation period of eight quarters.Fourth, mutual fund herding is positively related to the return of a contrarian strategy with formation and holding periods of less than one year and less than two years, respectively, or of more than two years and two quarters, respectively.This investigation also finds that the macroeconomic situation is negatively related to the payoff of the contrarian strategy over the specified formation and holding periods.In conclusion, this study shows that the payoff of a contrarian strategy can be explained by mutual fund herding behavior and macroeconomic variables.Investors should adopt a contrarian strategy for the Chinese stock market.Furthermore, the empirical results in this study reveal that mutual fund managers tend to copy the behaviors of other mutual fund managers and make similar decisions, so investors should consider the mutual fund herding and adjust their investment strategies accordingly.
Lakonishok et al. (1992)) Standard Deviation) methods, which are based on the early studies ofChristie and Huang (1995)andChang et al. (2000), are utilized to calculate herding behavior and measure the effect of herding on the returns of momentum strategy.Although the CSSD and CASD methods use the standard deviation of the cross-sectional return between stock market and individual stocks to measure the herding effect, the model that was developed byLakonishok et al. (1992)concerns changes in an investor's asset holding to evaluate the herding effect, and is therefore more intuitive.In this study, the method ofLakonishok et al. (1992)is used to evaluate mutual fund herding behavior.The model is expressed as Wang et al. (2014)sWang et al. (2014)to use the economic policy uncertainty.CASD

Table 1
presents descriptive statistics concerning stocks of interest and the herding effect of mutual funds.The stocks include A-shares and B-shares on the Shanghai and Shenzhen stock exchanges, as well as Growth Enterprise Market.The data are generated from a total of 2,832 stock quarterly returns.Herding refers to according to Eq. (1).The highest return of a stock in the Chinese stock market is 22.053%, while the lowest is -0.897%.

Table 1 . Descriptive statistics Variable Means Std. Dev. Minimum Maximum
Note: Dataset from 1995 to 2015 includes a total of 2,832 stock quarterly returns.Quarterly herding of mutual funds with respect to each stock is quantified using Eq.(1).

Table 2
presents empirical data concerning the contrarian strategy for the Chinese stock market.

Table 5 .
The impact of herding and macroeconomic indicator on returns of contrarian strategies