Financial Product Incentives to Differentiate: Evidence from Mutual Funds

Abstract

We investigate the strategic behavior of financial products in differentiating beyond performance, using mutual funds as our laboratory. We provide evidence consistent with low-performing funds strategically using product differentiation, reflected in more unique fund prospectuses, to compete for customers by offering more niche products. Exploiting the issuance of Morningstar ratings as a shock to perceived quality, we establish a causal link between low quality and increased differentiation. Funds receiving a low rating actively change their prospectuses, increasing their product differentiation, which improves their survival likelihood. Much like other consumer products, mutual funds strategically pursue product differentiation to soften quality-based competition.

Keywords: Product Differentiation, Mutual Funds, Industrial Organization, Textual Analysis, Ratings

JEL Classification: G23, G11, D83, L1