Investors' Misperception: A Hidden Source of High Markups in the Mutual Fund Industry
ETH Zurich, D-MTEC
University of Saint Etienne - Graduate School of Economics and Business Administration (ISEAG); EM Lyon (Ecole de Management de Lyon) - Department of Economics, Finance, Control
Swiss Finance Institute; ETH Zurich
January 1, 2009
Swiss Finance Institute Research Paper No. 09-04
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.
Number of Pages in PDF File: 47
Keywords: Mutual Fund Fees, Mutual Funds, Asymmetric Information, Principal-Agent, Relationships, Markup, Optimism Bias
JEL Classification: G23, G11, D82working papers series
Date posted: February 23, 2009 ; Last revised: February 25, 2009
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