The Valuation of Mutual Fund Contracts
48 Pages Posted: 4 Nov 2008
Date Written: May 2003
Combining insights from the contingent claims and the asset-backed securities literatures, we study the economics of value creation in the asset management business. In particular, we provide a theoretical model and a closed form formula for the value of fund fees in the presence of the well known flow-performance relation, giving rise to interesting nonlinearities and volatility-related effects. The theoretical model sheds light on the role of fees, asset growth, asset and benchmark volatility, and the intensity of the flow-performance relation. To better understand the role ofchanging fund characteristics such as age and size on the fund value and fund risk, we estimate theempirical relation between returns and flows conditional on these characteristics for various assetclasses. We study these effects using Monte Carlo simulations for various economically meaningfulparameter values for specific asset classes. Measuring value as a fraction of assets under management,we find that both value and risk, systematic and idiosyncratic, decline in size and age. In addition, value is a complex, non-monotonic function of the fee charged on the fund.
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