A Model of Mutual Fund Performance, Flows, and Fees with Rational Agents

Abstract

This paper develops a model with rational agents to study the patterns of performance, fund flows, and fees in the actively managed mutual fund industry. The model reproduces several empirical trends traditionally regarded as anomalous---fund performance fails to persist in the long term though it exhibits short term persistence, investors chase recent performance, and fees for funds with similar return histories can differ substantially. A few simple mechanisms lead to this results. Fund returns follow a Brownian Motion with drift equaling alpha, a fund manager's ability. However, alpha is itself time varying according to a mean reverting process (Ornstein-Uhlenbeck) with long run mean equaling zero. A consequence of these processes is that fund performance persists in the short term, but is on average non-existent. Because returns serve as noisy signals of alpha, investors learn about a manager's ability by observing his or her fund's history of returns in order to make optimal investment decisions. Since recently winning managers are more likely to be skillful at picking stocks in the near future and investors are aware of this, on average, assets flow to recent winners. However, performance is not the only dimension along which investors value funds. They also value extra-portfolio characteristics (fund age, size, ETF, advertising, manager-client services). Because these extra-portfolio characteristics often take time and effort to "produce", fund managers incur differing marginal costs. Consequently funds with similar performance histories but different marginal costs charge different fees in equilibrium.