Fund Managers' Competition for Investment Flows based on Relative Performance

Abstract

N mutual funds compete for fund flows based on relative performance over their average returns, by choosing between an idiosyncratic and a common risky investment opportunities. The unique constant equilibrium is derived in closed form, which imply that most funds decrease the investments in their idiosyncratic risky assets under competition, in order to lower the risk of the relative performance. It pushes all funds to herd and hurts their after-fee Sharp ratios. If a fund is sufficiently disadvantaged in the competition with poor investment opportunities, its investment can be excessively risky, and pushes all funds further away from their average. However, the performance of the disadvantaged funds can improve comparing to the case without competition and benefits the investors.

Keywords: Mutual Funds, Portfolio Choice, Relative Performance, Fund Flows, Equilibrium

JEL Classification: G11, G12