(Dis)Incentive Effects of Fund Flows in Money Management

Abstract

I present a dynamic investment model in which mutual funds' inferior performance is an equilibrium response to incentives rather than the consequence of low skills. In the model, a skilled (informed) manager responds to investors' flows, which are a convex function of performance relative to lesser-informed peers. The manager shifts risk in certain situations but herds with her peers in most other situations. While risk shifting exacerbates portfolio risk, herding leads to low excess returns. The resulting policy is overly conservative and hurts risk-adjusted performance. I present evidence consistent with the model over a sample of U.S. mutual funds.