A Signaling Theory of Mutual Fund Activeness

46 Pages Posted: 14 Feb 2019 Last revised: 30 Jun 2022

See all articles by Andrea M Buffa

Andrea M Buffa

University of Colorado at Boulder - Leeds School of Business

Apoorva Javadekar

Indian School of Business

Date Written: June 2022

Abstract

We propose a theory of self-selection in which fund managers choose two important dimensions of fund activeness: level of activeness and tracking error. To facilitate investor learning, skilled managers choose a level of activeness that maximizes the information ratio relative to that of unskilled managers. The latter, to hinder investor learning, scale up their tracking error (TE) with positive probability. In equilibrium, low-TE funds outperform high-TE funds, exhibit larger cross-sectional dispersion in performance, and higher flow-performance sensitivity. Improvements in fund reputation induce unskilled managers to rely more on investments with high TE. Our motivating evidence is consistent with these findings.

Keywords: signaling, self-selection, mutual funds, tracking error, investors' learning, fund flows, fund performance

JEL Classification: G23, D82

Suggested Citation

Buffa, Andrea M and Javadekar, Apoorva, A Signaling Theory of Mutual Fund Activeness (June 2022). Indian School of Business, Available at SSRN: https://ssrn.com/abstract=3327638 or http://dx.doi.org/10.2139/ssrn.3327638

Andrea M Buffa (Contact Author)

University of Colorado at Boulder - Leeds School of Business ( email )

Boulder, CO 80309-0419
United States

Apoorva Javadekar

Indian School of Business ( email )

Hyderabad, Gachibowli 500 019
India

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