EITM: An Investigation of Intermediation in the Mutual Fund Industry

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

The purpose of this research is to derive and test a model of money management that can simultaneously explain the salient features of the industry. There are a number of economic regularities that characterize this industry, specifically, oActive mutual fund managers do not appear to outperform passive benchmarks, indeed the evidence is that they under perform. oManagers that do outperform cannot seem to do so consistently --- performance in one period has little predictability for future periods. oYet investors appear to chase performance --- when a manager does well (badly) investment in the fund flows in (out). oClosed end mutual funds generally trade below their net asset values. These facts are widely interpreted as evidence that managerial out-performance is attributable to luck rather than skill. Yet mutual fund managers are richly rewarded. Why then do intermediaries with apparently little talent earn such high rents? Another puzzling aspect of the industry is the existence of two different managerial compensation contracts. That is, mutual fund managers are generally paid a fixed percentage of the amount of assets under management. However, hedge fund mangers get an additional incentive fee --- they get a percentage of any positive return they generate. Given that the mutual fund contract is not incentive based, and that hedge fund managers generally do better than mutual fund managers, one might be tempted to conclude that the explanation might be that the mutual fund labor contract is inefficient. At the very least, the existence of two different types of contracts for essentially the same service is puzzling. In the face of this evidence many researchers have concluded that a consistent explanation of these regularities is impossible without appealing to behavioral arguments that depend on irrationality, or to elaborate theories based on asymmetric information or moral hazard. Before appealing to these additional effects it makes sense to first establish which behaviors in the data are qualitatively and quantitatively consistent with more direct explanations. That is the primary objective of this research proposal. The investigator will offer a parsimonious explanation of why the industry is characterized by the above regularities by showing that they can all be derived within with a fully rational economic model that features competitive capital and labor markets. Broader Impact Although understanding the role of mutual fund managers in the economy has important economic implications, this research also addresses the role of intermediaries in society in general. Much of what is learned from this research is not specific to mutual funds --- it applies broadly to other areas of intermediation. The model itself uses four distinct branches of economic theory (financial asset pricing, information economics, contracting and labor economics) to provide a general theory of intermediation rather than just mutual fund management. The ideas developed can potentially help economists understand more generally the role of intermediation in the economy.