Star Ratings and the Incentives of Mutual Funds
68 Pages Posted: 9 Jul 2014 Last revised: 9 Sep 2019
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: Suggested Citation