Dynamic Contracting in the Mutual Fund Industry
43 Pages Posted: 19 Mar 2005
Date Written: February 15, 2005
In June 2004, the Securities and Exchange Commission (SEC) adopted a new rule requiring enhanced disclosure regarding the approval of investment advisory contracts by the boards of directors of mutual funds. The SEC's interest in changing the disclosure rules regarding advisory contracts indicates there could be inefficiencies in the way funds choose and pay investment advisory firms. The goal of this paper is to study the funds' decisions regarding advisory fees and changes of advisors, and to understand their implications for fund peformance and inflows.
This paper analyzes the dynamics of contractual agreements between mutual funds and investment advisors using a new dataset that covers U.S. funds between 1993-2002. I show that funds rarely experience contractual renegotiation and advisor changes. I also find cross-sectional and time-series determinants of advisory contracts. I show that fee-setting as well as firing decisions regarding the advisory firms are not only related to performance, but to other fund characteristics, such as differences in portfolio risk, ease of monitoring, economies of scale, restrictions on investors' actions, as well as differences between the bargaining power of the funds and their advisors. The sensitivity of the advisory fee to past performance is non-linear: for bottom- and mid-performers it is negative and significant, while for top performers it is positive and significant.
Last, I show that advisory changes are beneficial: decreases in advisory rates significantly increase subsequent fund performance and net inflows. Separating from an advisor has a significant positive effect on the subsequent ranking of mid-performing funds. These results are puzzling: contractual changes are rare, in spite of their economically significant benefits.
Keywords: Mutual funds, contracts, corporate governance
JEL Classification: G2, G3, L14
Suggested Citation: Suggested Citation