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(Dis)Incentive Effects of Fund Flows in Money Management

66 Pages Posted: 20 Aug 2012 Last revised: 15 Apr 2017

Juan M. Sotes-Paladino

University of Melbourne - Department of Finance

Date Written: February 2017

Abstract

I present a dynamic investment model in which mutual funds' inferior performance is an equilibrium response to incentives rather than the consequence of low skills. In the model, a skilled (informed) manager responds to investors' flows, which are a convex function of performance relative to lesser-informed peers. The manager shifts risk in certain situations but herds with her peers in most other situations. While risk shifting exacerbates portfolio risk, herding leads to low excess returns. The resulting policy is overly conservative and hurts risk-adjusted performance. I present evidence consistent with the model over a sample of U.S. mutual funds.

Keywords: Portfolio delegation, mutual funds, incomplete information, fund flows, herding, performance evaluation

JEL Classification: D82, D83, G11, G23

Suggested Citation

Sotes-Paladino, Juan M., (Dis)Incentive Effects of Fund Flows in Money Management (February 2017). Available at SSRN: https://ssrn.com/abstract=2132366 or http://dx.doi.org/10.2139/ssrn.2132366

Juan M. Sotes-Paladino (Contact Author)

University of Melbourne - Department of Finance ( email )

Faculty of Economics and Commerce
Parkville, Victoria 3010 3010
Australia
+61 3 9035 9827 (Phone)
+61 3834 6914 (Fax)

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