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Smart Fund Managers? Stupid Money?

  • Dan Bernhardt


    (Department of Economics, University of Illionis)

  • Ryan Davies


    (ICMA Centre, University of Reading)

  • Harvey Westbrook Jr.


    (Securities and Exchange Commission, Washintgon DC)

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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Paper provided by Henley Business School, Reading University in its series ICMA Centre Discussion Papers in Finance with number icma-dp2002-19.

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Length: 32 pages
Date of creation: Sep 2002
Date of revision: Jul 2003
Handle: RePEc:rdg:icmadp:icma-dp2002-19
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  1. Chevalier, Judith & Ellison, Glenn, 1997. "Risk Taking by Mutual Funds as a Response to Incentives," Journal of Political Economy, University of Chicago Press, vol. 105(6), pages 1167-1200, December.
  2. Brown, Stephen J & Goetzmann, William N, 1995. " Performance Persistence," Journal of Finance, American Finance Association, vol. 50(2), pages 679-98, June.
  3. Bernhardt, Dan & Hughson, Eric, 1993. "Intraday Trade in Dealership Markets," Working Papers 852, California Institute of Technology, Division of the Humanities and Social Sciences.
  4. Chan, Louis K C & Lakonishok, Josef, 1995. " The Behavior of Stock Prices around Institutional Trades," Journal of Finance, American Finance Association, vol. 50(4), pages 1147-74, September.
  5. Keim, Donald B. & Madhavan, Ananth, 1997. "Transactions costs and investment style: an inter-exchange analysis of institutional equity trades," Journal of Financial Economics, Elsevier, vol. 46(3), pages 265-292, December.
  6. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
  7. Easley, David & Kiefer, Nicholas M & O'Hara, Maureen, 1997. "One Day in the Life of a Very Common Stock," Review of Financial Studies, Society for Financial Studies, vol. 10(3), pages 805-35.
  8. Lakonishok, Josef, et al, 1991. "Window Dressing by Pension Fund Managers," American Economic Review, American Economic Association, vol. 81(2), pages 227-31, May.
  9. William N. Goetzmann & Nadav Peles, 1997. "Cognitive Dissonance And Mutual Fund Investors," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 20(2), pages 145-158, 06.
  10. Malkiel, Burton G, 1995. " Returns from Investing in Equity Mutual Funds 1971 to 1991," Journal of Finance, American Finance Association, vol. 50(2), pages 549-72, June.
  11. Chan, Louis K C & Lakonishok, Josef, 1997. " Institutional Equity Trading Costs: NYSE versus Nasdaq," Journal of Finance, American Finance Association, vol. 52(2), pages 713-35, June.
  12. Edelen, Roger M., 1999. "Investor flows and the assessed performance of open-end mutual funds," Journal of Financial Economics, Elsevier, vol. 53(3), pages 439-466, September.
  13. Erik R. Sirri & Peter Tufano, 1998. "Costly Search and Mutual Fund Flows," Journal of Finance, American Finance Association, vol. 53(5), pages 1589-1622, October.
  14. Mark M. Carhart & Ron Kaniel & David K. Musto & Adam V. Reed, 2002. "Leaning for the Tape: Evidence of Gaming Behavior in Equity Mutual Funds," Journal of Finance, American Finance Association, vol. 57(2), pages 661-693, 04.
  15. Edelen, Roger M. & Warner, Jerold B., 2001. "Aggregate price effects of institutional trading: a study of mutual fund flow and market returns," Journal of Financial Economics, Elsevier, vol. 59(2), pages 195-220, February.
  16. Chen, Hsiu-Lang & Jegadeesh, Narasimhan & Wermers, Russ, 2000. "The Value of Active Mutual Fund Management: An Examination of the Stockholdings and Trades of Fund Managers," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 35(03), pages 343-368, September.
  17. Ippolito, Richard A, 1992. "Consumer Reaction to Measures of Poor Quality: Evidence from the Mutual Fund Industry," Journal of Law and Economics, University of Chicago Press, vol. 35(1), pages 45-70, April.
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