Investors’ Expectations, Management Fees and the Underperformance of Mutual Funds
Andreas D. Huesler
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
February 3, 2012
Swiss Finance Institute Research Paper No. 12-01
Why do investors keep buying underperforming mutual funds? To address this issue, we develop a one-period principal-agent model with a representative investor and a fund manager in an asymmetric information framework. This model shows that the investor’s perception of the fund plays the key role in the fund’s fee-setting mechanism. Using a simple relation between fees and funds’ performance, empirical evidence suggests that most US domestic equity mutual funds have added high markups during the period from July 2003 to March 2007. For these fees to be justified, we show that the investor would have expected the fund manager to deliver an overall annual net excess-return of around 1.5% the S&P 500 on a risk adjusted basis. In addition, our model offers a new classification of funds, based on their ability to provide benefits to investors’ portfolios.
Number of Pages in PDF File: 60
Keywords: Mutual Fund Fee, Mutual Fund, Asymmetric Information, Principal-Agent Relationship, Markup
JEL Classification: G23, G11, D82
Date posted: February 6, 2012
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