Are Mutual Fund Investors Paying for Noise?
62 Pages Posted: 16 Mar 2015 Last revised: 6 May 2015
Date Written: March 26, 2015
We demonstrate that advisory fees exhibit a positive concave dependence on the idiosyncratic volatilities of mutual fund returns. Our theoretical analysis attributes this to the impact of idiosyncratic noise on performance opacity, coupled with the infeasibility of short-selling mutual fund shares. Echoing the literature on the principal-agent model for executive compensation, we show that previous estimates of the fee-performance sensitivity for mutual funds are negatively biased, since they do not account for the impact of idiosyncratic noise on fees and performance. Finally, we show that investor sophistication reduces the dependence of advisory compensation on idiosyncratic noise.
Keywords: Advisory fees, idiosyncratic noise, short-selling constraints
JEL Classification: C72, D58, D83, G11, G12, G23
Suggested Citation: Suggested Citation