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Mutual funds flows and the "Sheriff of Nottingham" effect

  • Lucia Milone

    (Department of Applied Mathematics, University of Venice)

  • Paolo Pellizzari

    ()

    (Department of Applied Mathematics and SSAV, University of Venice)

Investors in mutual funds appear to reward disproportionately the best performing funds with large inflows while, at the same time, avoid to withdraw similar amounts from the poorly managed funds. We show that this peculiar flat-convex shape of the flow-performance curve for mutual funds can be generally explained by a model where profit chasing customers punish the bad funds by switching a fraction of their wealth to the best ones ("Sheriff of Nottingham" effect). In the absence of external flows, the model provably produces a constant curve when the standard deviation of excess returns is much larger than the level of the returns. This for the most part explains the apparent insensitivity of flows to below-average returns. The introduction of exogenous injections of money invested in the top funds completes the model and provides a realistic increase in the flows of the funds yielding above-average returns. We finally show by simulation that our results are robust to variations in the values of the parameters of the model.

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File URL: http://virgo.unive.it/wpideas/storage/2009wp188.pdf
File Function: First version, 2009
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Paper provided by Department of Applied Mathematics, Università Ca' Foscari Venezia in its series Working Papers with number 188.

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Length: 14 pages
Date of creation: Jun 2009
Date of revision:
Handle: RePEc:vnm:wpaper:188
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  1. W. Brian Arthur & John H. Holland & Blake LeBaron & Richard Palmer & Paul Taylor, 1996. "Asset Pricing Under Endogenous Expectation in an Artificial Stock Market," Working Papers 96-12-093, Santa Fe Institute.
  2. Lettau, Martin, 1997. "Explaining the facts with adaptive agents: The case of mutual fund flows," Journal of Economic Dynamics and Control, Elsevier, vol. 21(7), pages 1117-1147, June.
  3. Guercio, Diane Del & Tkac, Paula A., 2008. "Star Power: The Effect of Monrningstar Ratings on Mutual Fund Flow," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 43(04), pages 907-936, December.
  4. Kosowski, Robert & Timmermann, Allan & Wermers, Russ & White, Hal, 2005. "Can mutual fund stars really pick stocks? New evidence from a bootstrap analysis," CFR Working Papers 05-14, University of Cologne, Centre for Financial Research (CFR).
  5. Jonathan B. Berk & Ian Tonks, 2007. "Return Persistence and Fund Flows in the Worst Performing Mutual Funds," NBER Working Papers 13042, National Bureau of Economic Research, Inc.
  6. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  7. 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.
  8. Anthony W. Lynch & David K. Musto, 2003. "How Investors Interpret Past Fund Returns," Journal of Finance, American Finance Association, vol. 58(5), pages 2033-2058, October.
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