Familiarity and Competition: The Case of Mutual Funds

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