This study examines how market sentiment affects the price impact of mutual funds' herding behavior in the Chinese A-share market, and further explores its connection to the momentum effect. Our evidence shows that mutual fund herding predicts future stock returns only when market sentiment is high. During such periods, stocks heavily bought by mutual funds outperform those heavily sold by mutual funds by 7% in the next six months, with no strong reversal thereafter. This pattern disappears under low sentiment. Building on these findings, we develop a profitable momentum strategy in the Chinese A-share market—where conventional momentum strategies typically fail—by focusing on stocks actively traded by mutual funds. The excess returns of this strategy are concentrated in high-sentiment periods, and additional evidence suggests that mutual fund herding behavior plays an important role in determining whether stock price momentum persists.

A substantial literature in institutional herding examines reasons for and evidence of correlated trading across institutional investors, but little has been written about the extent to which individual investor trading is correlated or why. We document that the trading of individuals is highly correlated and surprisingly persistent. Furthermore, we find that the systematic trading of individual investors is driven by their own decisions―trades they initiated―rather than by passive reactions to institutional herding. We discuss why this correlation is unlikely to stem from the same motivations as institutional herding. Correlated trading by individual is a necessary condition for the trading biases of individual investors to affect asset prices, since the trades of any particular individual are likely to be small. The preferences for buying some stocks while selling others must be shared by many individual investors if these preferences are to affect prices. We analyze trading records for 66,465 households at a large national discount broker between January 1991 and November 1996 and 665,533 investors at a large retail broker between January 1997 and June 1999. Using a variety of empirical approaches, we document that the trading of individuals is more coordinated than one would expect by mere chance. For example, if individual investors are net buyers of a stock this month, they are likely to be net buyers of the stock next month. In additional analyses, we present four stylized facts about the trading of individual investors: (1) they buy stocks with strong past returns; (2) they also sell stocks with strong past returns, though this relation is stronger than that for buys at short horizons (one to two quarters), but weaker at long horizons (up to 12 quarters); (3) their buying is more concentrated in fewer stocks than selling; and (4)they are net buyers of stocks with unusually high trading volume.