Dan Bernhardt () (Department of Economics, University of Illionis) Ryan Davies () (ICMA Centre, University of Reading) Harvey Westbrook Jr. () (Securities and Exchange Commission, Washintgon DC)
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We develop a theoretical model of a mutual fund manager’s investment decision that incorporates three well-known observations: (i) past fund performance influences subsequent net fund inflows; (ii) fund manager compensation rises with total assets under management; (iii) trading has short-run price impacts. These observations provide fund managers the incentive to distort investment of new cash inflows toward stocks in which the fund holds larger positions. We show that this leads to the empirically observed short-run persistence and long-run reversal in fund performance. It also explains why mutual funds tend to be relatively undiversified and appear to exhibit clairvoyant stock selection.
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Find related papers by JEL classification: D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information G2 - Financial Economics - - Financial Institutions and Services G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
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