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Star-rating Effects and the Incentives of Mutual Funds

43 Pages Posted: 9 Jul 2014 Last revised: 27 Oct 2016

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: October 26, 2016

Abstract

Mutual funds’ flows are sensitive to their star ratings. Such so-called “star-rating effects” are usually attributed to investors' attention, treated as exogenous to funds’ future performance, and thus used to identify the causal effects of funds’ sizes on their performance. In this paper, however, we show that in equilibrium, star ratings affect funds’ incentives to acquire information. Specifically, when a fund has just been upgraded to a higher star group, its incentives have a discrete jump, and so does its expected performance. Investors anticipate such an effect and invest more. Therefore, the star-rating effects are correlated to funds’ future performance.

Keywords: Mutual Fund, Reputation, Information Superiority, Information Acquisition, Obsolete Information, Morningstar

JEL Classification: C73, D83, G23

Suggested Citation

Huang, Chong and Li, Fei and Weng, Xi, Star-rating Effects and the Incentives of Mutual Funds (October 26, 2016). 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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