Inferring Mutual Fund Quality At Inception

Abstract

We show that poor mutual fund performance can result from agency problems that drive fund inceptions. Funds created to exploit investor irrationality have different portfolio compositions at inception, loading heavily on past winner stocks. Investors reward these funds with abnormally high inflows but only until the fund accumulates a performance history of sufficient length. Funds then rebalance their portfolios away from winner stocks incurring abnormally high turnover. Higher tilt towards winners at inception predicts fund underperformance for up to eight years. These results suggest that portfolios of young funds contain valuable information about the motives behind the fund’s initiation. Agency-driven initiations can explain proliferation of inferior funds.