Mutual Fund Portfolio Choice in the Presence of Dynamic Flows
56 Pages Posted: 18 Nov 2002 Last revised: 28 Sep 2008
Date Written: February 13, 2008
We analyze the implications of dynamic flows on a mutual fund manager's portfolio decisions. In our model, a myopic investor is allowed to dynamically allocate capital between a riskless asset and an actively managed mutual fund who charges fraction of fund fees. The presence of dynamic flows induces flow hedging portfolio distortions on the part of the fund, even though the investor is myopic. Our model predicts a positive relationship between a fund's proportional fee rate and its volatility. This is a consequence of higher fee funds holding more extreme equity positions. While both the fund portfolio and the investor's trading strategy depend on the proportional fee rate, the equilibrium value functions do not. Implications related to the measured performance-fund flow relationship and its dependence on the level of the fee rate are derived. Finally, we show that our results hold even if the investor is allowed to directly trade some, but not all, of the risky securities.
JEL Classification: G11, G12, G13, G23, D81
Suggested Citation: Suggested Citation