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Investors’ Misperception: A Hidden Source of High Markups in the Mutual Fund Industry

Listed author(s):
  • Shengsui HU

    (ETH Zurich)

  • Yannick MALEVERGNE

    (University of Saint-Etienne and EM-Lyon Business School)

  • Didier SORNETTE

    (ETH Zurich and Swiss Finance Institute)

We develop a principal-agent model based on a sequential game played by a representative investor and a fund manager in an asymmetric information framework. The model shows that investors’ perceptions of the fund market play the key role in the fund’s fee-setting mechanism. The managers’ true ability to deliver performance is not relevant. Along with a simple relation between fees and funds’ performance, empirical evidence suggests that most U.S. domestic equity mutual funds have added high markups in recent years. We show that, for these fees to be justified, investors would have expected the fund managers to be able to deliver an overall annual excess-return of around 3% over the S&P 500, net of fees, irrespective of the investment style and of the risk level of the funds. Therefore, we interpret these high markups as resulting from the investors’ optimism bias whose root can be found in their lack of financial literacy as well as in funds’ marketing effort.

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Paper provided by Swiss Finance Institute in its series Swiss Finance Institute Research Paper Series with number 09-04.

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Length: 47 pages
Date of creation:
Handle: RePEc:chf:rpseri:rp0904
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