This study examines the role of mutual funds in the pricing of accruals in China's stock market to evaluate the sophistication of Chinese mutual funds. Using a sample of A-share stocks in China from 2003 to 2011, I find that the mispricing of accruals is concentrated in firms with large mutual fund holdings. This result differs from a number of U.S. studies documenting a positive relation between institutional holdings and stock price efficiency. In an effort to explain this result, I provide evidence that mutual funds in China fixate on earnings and fail to understand the one-year-ahead earnings implication of accruals. Specifically, I find that the persistence of accruals is overpriced in stocks with a high level of mutual fund ownership. The mispricing of accruals in these stocks is largely driven by discretionary accruals and is related to their high stock price responsiveness to earnings.
JEL Classifications: M41; G12.