Quality and Product Differentiation: Theory and Evidence from the Mutual Fund Industry
71 Pages Posted: 11 Oct 2021 Last revised: 27 Jul 2022
Date Written: October 8, 2021
We study product differentiation in the mutual fund industry. We introduce a model in which funds with heterogeneous quality compete for investors by setting their level of product differentiation. In equilibrium, low-quality funds choose to be more differentiated and cater to a smaller set of investors. Using textual analysis of fund prospectuses, we confirm empirically that funds with lower expected performance—low-quality funds—tend to be more differentiated. To test this mechanism, we use the publication of Morningstar rating to capture shocks to fund perceived quality. Funds receiving a low rating respond by increasing their product differentiation, which makes them less likely to die out. This has a market-level impact on the menu of funds available to investors.
Keywords: Mutual Funds, Product Differentiation, Market Structure, Textual Analysis, Ratings
JEL Classification: G23, G11, D83, L1
Suggested Citation: Suggested Citation