Financial Product Differentiation Over the State Space in the Mutual Fund Industry

Abstract

By distancing themselves from others in risk factor loadings, mutual funds yield distinct returns and become winning funds alternatively in different market situations. This enables mutual funds to obtain stochastic monopoly power and charge higher fees than they could otherwise. This strategy fundamentally differs from the conventional market segmentation strategy that targets investors with heterogeneous preferences. We develop a model to study this novel form of financial product differentiation over the states of nature in the mutual fund industry. The empirical evidence provides strong support to our model. We find that the returns attributable to risk factor loadings have significant impact on a mutual fund’s market share. The distribution of risk factor loadings in mutual fund industry is highly dispersed and persistent. Fund fees are related to the positions of their factor loadings in the industry and funds with more extreme risk factor loadings charge higher fees.

Keywords: Mutual Fund, Product Differentiation, Market Share, Fee, Stochastic

JEL Classification: G2, L1, L2