Mutual Funds and Bubbles: The Surprising Role of Contractual Incentives
66 Pages Posted: 25 Jul 2005
Date Written: November 2006
This paper studies one of the potential causes of the financial market bubble of the late 1990s: herding behavior of mutual funds. We show that the incentives contained in the mutual funds' advisory contracts induce managers to overcome their tendency to herd. We argue that investing in bubble stocks amounts to herding and contracts with high incentives induce managers to diverge from the herd, thus reducing their holding of bubble stocks. The differential exposure to bubble stocks significantly impacted the funds' performance both in the period prior to March 2000 as well as afterwards.
Keywords: Bubbles, mutual funds, compensation, herding, agency
JEL Classification: G23, G30, G31, G32
Suggested Citation: Suggested Citation