Mutual-fund managers who lack experience or resources tend to beswayed by a home state advantage, according to a new study fromIndiana University's Kelley School of Business.

While it's common for portfolios to show a preference for nearbycompanies, it hasn't been clear whether bias or a greater amount ofinformation drives the predisposition toward investing in familiarcompanies, such as those headquartered in the manager's home state.A forthcoming paper in the Review of Financial Studies,“No Place Like Home: Familiarity in Mutual Fund Manager PortfolioChoice,” is the first to document and quantify this bias amongprofessional investors. The studyby three Kelley School professors examined 42,109 quarterly fundobservations for more than 2,000 funds.

Fund managers overweighted stocks from their home state by 12%compared with stocks from other states, according to the paper,investing an estimated $31 billion per year based on familiarity.The bias increased among fund managers who had less experience,fewer resources or had spent more time in their home state.

Research shows that managers also tend to invest more in localcompanies, but those investments perform better than investments inother stocks, indicating that greater knowledge of the companiesdrives the selection. Managers who overweighted companies fromtheir home state, rather than the city they reside in, did not seebetter results, indicating that superior knowledge did not drivethe investment.

Home-state holdings underperformed the fund's local holdings,but performed similarly to the rest of the portfolio, the studyfound. But it argues that an overweighting in home-state stockscreates excess risk, in part because it leads to a lack ofdiversity in the portfolio.

The most biased managers' funds were underdiversified andinefficient. The study measured bias on a per-manager basis andfound that for funds with multiple managers, the effect wasamplified, creating portfolios with even greater overinvestment inhome-state companies.

“We think that an implication is that investors may want todiversify across mutual funds,” says Noah Stoffman, a co-author ofthe study and an assistant professor of finance at the KelleySchool. The results also seemed to indicate that there's a benefitto investing with more experienced mutual-fund managers at largercompanies, Stoffman says, since the bias was more pronounced amongmanagers with less experience and fewer resources.