Star Ratings and the Incentives of Mutual Funds

68 Pages Posted: 9 Jul 2014 Last revised: 9 Sep 2019

See all articles by Chong Huang

Chong Huang

University of California, Irvine - Paul Merage School of Business

Fei Li

University of North Carolina (UNC) at Chapel Hill

Xi Weng

Peking University

Date Written: September 6, 2019

Abstract

We propose a theory of reputation to explain how investors rationally respond to mutual fund star ratings. A fund's performance is determined by its information advantage, which can be acquired but decays stochastically. Investors form beliefs about whether the fund is informed based on its past performance. We refer to such beliefs as fund reputation that determines fund flows. As performance changes continuously, equilibrium fund reputation may take discrete values only and thus can be labeled by stars. Star upgrade then implies reputation jump, leading to discrete increases in flows and expected performance, although stars do not provide new information.

Keywords: Mutual Fund, Star Ratings, Reputation, Information Acquisition, Morningstar

JEL Classification: C73, D83, G23

Suggested Citation

Huang, Chong and Li, Fei and Weng, Xi, Star Ratings and the Incentives of Mutual Funds (September 6, 2019). Journal of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2463364 or http://dx.doi.org/10.2139/ssrn.2463364

Chong Huang (Contact Author)

University of California, Irvine - Paul Merage School of Business ( email )

Irvine, CA 92697-3125
United States

Fei Li

University of North Carolina (UNC) at Chapel Hill ( email )

102 Ridge Road
Chapel Hill, NC NC 27514
United States

Xi Weng

Peking University ( email )

Beijing, 100871
China

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