Familiarity and Competition: The Case of Mutual Funds

47 Pages Posted: 13 Mar 2015 Last revised: 14 Jul 2016

See all articles by Ariadna Dumitrescu

Ariadna Dumitrescu

ESADE Business School

Javier Gil-Bazo

Universitat Pompeu Fabra; Barcelona Graduate School of Economics (Barcelona GSE)

Date Written: July 13, 2016

Abstract

We build a model of mutual fund competition in which a fraction of investors, unsophisticated, exhibit a preference for familiarity, while sophisticated investors are free of familiarity bias. Funds differ in two dimensions: quality and familiarity. Unsophisticated investors exhibit varying degrees of familiarity with respect to high-familiarity funds and avoid low-familiarity funds altogether. In equilibrium, bad low-familiarity funds do not operate as they cannot compete against good funds for sophisticated investors. High-familiarity funds do not engage in competition for sophisticated investors either, and choose instead, to cater only to unsophisticated investors. If unsophisticated investors' familiarity bias is high enough, bad high-familiarity funds survive competition from higher quality funds despite offering lower after-fee performance. Our model can thus shed light on the presence of persistently underperforming funds in the market. But it also delivers a completely new prediction: Persistent cross-sectional differences in performance should be observed among high-familiarity funds but not in the more competitive low-familiarity segment of the market. Using data on US domestic equity funds, we find strong evidence supporting this prediction.

Keywords: familiarity bias, competition, mutual funds, performance persistence

JEL Classification: G2, G23

Suggested Citation

Dumitrescu, Ariadna and Gil-Bazo, Javier, Familiarity and Competition: The Case of Mutual Funds (July 13, 2016). Available at SSRN: https://ssrn.com/abstract=2576903 or http://dx.doi.org/10.2139/ssrn.2576903

Ariadna Dumitrescu

ESADE Business School ( email )

Av. Pedralbes 60-62
Barcelona, 08034
Spain

Javier Gil-Bazo (Contact Author)

Universitat Pompeu Fabra ( email )

Ramon Trias Fargas, 25-27
Barcelona, 08005
Spain

Barcelona Graduate School of Economics (Barcelona GSE) ( email )

Ramon Trias Fargas, 25-27
Barcelona, Barcelona 08005
Spain

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