Investment Restrictions and Fund Performance

Abstract

We examine why mutual funds appear to underperform hedge funds. Utilizing a unique panel of mutual fund contracts changes, we explore several possible channels, including: alternative investment practices (e.g., short sales and leverage), performance-based compensation, and the ability to restrict the funding risk of fund flows. We document that over our sample period, mutual funds were more likely to shift their contracting environment closer to that of hedge funds. However, this shift provided no benefit to mutual funds and we find no causal link between these contract changes and improvements in performance. Rather, our results cast doubt on the binding nature of investment restrictions in the mutual fund industry.

Keywords: Mutual funds; Hedge funds; Limits to arbitrage

JEL Classification: G23, G32