Sentiment trading and mutual fund performance

Abstract

Mutual funds employ different trading strategies when facing sentiment fluctuations. Using the exposure to sentiment changes as the sorting variable, I find that the funds with higher sentiment beta outperform funds with lower sentiment beta, even after adjusting risk factors and controlling for fund characteristics. The return spread between the two extreme deciles is sizable, delivering outperformance of 3.36% per year. This effect is stronger when the sentiment level is high, and the alpha is mainly generated during high sentiment periods. Further, I find that the timing ability could explain a large fraction of the outperformance. In addition, high sentiment beta funds managers deliberately choose unconventional strategies and exhibit higher managerial skills. My findings suggest that skilled mutual funds may engage in sentiment trading strategy, ride the sentiment bubble, and profit from sentiment fluctuations.