Local Economic Conditions and Local Equity Preferences: Evidence from Mutual Funds during the U.S. Housing Boom and Bust

This paper examines the impact of local economic conditions on mutual fund preferences for geographically proximate stocks and consequently fund rerformance. Specificcally, we demonstrate that mutual funds favouritism towards firms located within close geographic proximity varies with local housing price shocks. A decrease in local house prices is strongly associated with an increase in mutual fund home bias and results in a portfolio adjustment towards safer and higher quality holdings. This previously undocumented behavioral bias is of first order importance, as the shift in mutual fund preferences towards local stocks induced by deterioration in local economic conditions is associated with mutual fund underperformance: a one percentage point increase in the fraction of local holdings causes a decrease in a fund's characteristic-adjusted 3-month future return by 35.3 bps.