Entry, Competition, and Welfare in the Mutual Fund Industry

University Of Chicago, Chicago IL

Investigators

Abstract

This research explores a number of facets of the competitive market structure in the U.S. mutual fund industry, specifically with regard to the nature of mutual fund firms' strategic decisions. While a considerable amount of research in financial economics has been devoted to mutual funds, its primary focus has been on aspects of mutual fund operation in isolation from other industry firms: portfolio construction, evaluation of fund performance vis-a-vis benchmark portfolios, and the agency relationship between shareholders and the fund manager. Previous research has not delved greatly into the strategic decisions of industry firms. The project fills this gap and builds on the recent increase of interest among financial economists in the mutual fund industry's competitive structure. It explicitly models several aspects of competitive behavior in the industry, offering testable and excludable hypotheses. It also investigates elements of industry competition that have not been studied in depth. Specific questions that this project addresses include the following: (1) Do investors face significant search costs/informational frictions when choosing funds? (2) What non-risk or return attributes characterize investors' demand for mutual funds? (3) How do fund companies set management fees? (4) What non-price aspects of competition exist in the mutual fund industry? (5) Is the existing competitive structure of the industry optimal from a social welfare standpoint? The project takes several approaches to this aim. Specific topics are investigated in sector case studies that control for confounding influences on outcomes and highlight the competitive decision(s) of interest. Further, the research involves modeling market interactions and the estimation of the models' structural parameters using market data. This allows the evaluation of actual, anticipated, or proposed market changes on industry structure and consumer and social welfare, facilitating policy counterfactuals and hypothesis testing. This research offers potentially substantial broader impact. The mutual fund industry is an important part of the domestic financial system, and as such has been of great interest to popular media, regulators, and policymakers. In 2001, for example, over half of U.S. households had mutual fund holdings, and various institutional fiduciaries held over $3 trillion in assets. The industry also plays a major role in households' retirement plans: roughly one-third of mutual fund assets are held in retirement savings vehicles. Given its size and ubiquity, the industry's competitive market structure and the strategic decisions shaping it directly affect not only the fortunes of individual funds and fund families, but consumer welfare as well. Improved understanding of these decisions and how they respond to real and prospective changes in the competitive environment will undoubtedly yield useful insights to researchers and policymakers. Furthermore, the project's research synthesizes elements of the relevant finance literature with industrial organization research on consumer search behavior, product differentiation, producer entry, and oligopolistic price competition. As such, it holds considerable potential to spur additional interchange of theoretical and empirical ideas and methodologies between the industrial organization and finance literatures. The research program will emphasize the development of novel empirical methods and probe the applicability of current analytical tools of the industrial organization literature to the financial economics arena.