Cross-section return dispersion and flow-performance sensitivity: Evidence from Chinese mutual fund

For actively managed equity mutual funds, cross-sectional return dispersion is inevitable. Cross-sectional return dispersion makes it more challenging for investors to assess managerial skills accurately. This study examines the impact of cross-sectional return dispersion on flow-performance sensitivity (FPS) with actively managed equity mutual funds from 2006 to 2020. Our findings reveal a significant negative impact of cross-section return dispersion on FPS, suggesting that unskilled managers may disguise their lack of skill more easily in the high-dispersion period. Furthermore, we also provide evidence that the traditional convex relationship between fund flows and performance cannot fully explain the influence of return dispersion. After controlling for flow-performance convexity, we find that the impact of dispersion on the FPS is greater in well-performing funds than in poor-performing ones. Star funds are more sensitive to dispersion compared to dog funds, which is consistent with the findings in flow-performance convexity. Moreover, the negative impact of dispersion on performance evaluation is more pronounced in bear markets or extreme market conditions, highly competitive funds, large-cap funds, actively managed funds, and individual investors. These findings enhance our understanding of how return dispersion shapes investor behavior and fund performance evaluation in actively managed mutual funds. • We examine the impact of cross-sectional return on FPS in China's actively managed equity mutual funds. • Our results show higher return dispersion weakens FPS, meaning unskilled managers can hide incompetence in high dispersion periods. • Return dispersion affects FPS more in well-performing funds than poor ones; star funds are more sensitive to it. • The negative impact of return dispersion is more obvious in bear/extreme markets and for large-cap, competitive, actively managed funds. • These findings improve understanding of how return dispersion affects investor behavior and fund performance evaluation in active mutual funds.