Title: Investors' expectations, management fees and the underperformance of mutual funds

Authors: Andreas Huesler; Yannick Malevergne; Didier Sornette

Addresses: Department of Management, Technology and Economics, ETH Zurich, Scheuchzerstrasse 7, 8092 Zurich, Switzerland ' Université de Lyon, Coactis EA 4161, 6 rue basse des rives, 42023 Saint-Etienne, France; EMLYON Business School, 23 avenue Guy de Collongue, 69134 Ecully, France ' Department of Management, Technology and Economics, ETH Zurich, Scheuchzerstrasse 7, 8092 Zurich, Switzerland; Swiss Finance Institute, C/o University of Geneve, 40, Bd du Pont-d'Arve, 1211 Geneva, Switzerland

Abstract: Why do investors buy underperforming mutual funds? To address this issue, we develop a one-period principal-agent model with a representative investor and a fund manager in an asymmetric information framework. This model shows that the investor's perception of the fund plays a key role in the fund's fee-setting mechanism. Using a simple relation between fees and funds' performance, empirical evidence suggests that most US domestic equity mutual funds have added high markups during the period from July 2003 to March 2007. For these fees to be justified, we show that the investor would have expected the fund manager to deliver an overall annual net excess-return of around 1.5% above the S&P500 on a risk adjusted basis. In addition, our model offers a new classification of funds, based on their ability to provide benefits to investors' portfolios.

Keywords: fund fee; management fees; asymmetric information; markup; investor expectations; fund underperformance; principal-agent relationship; mutual funds; fund performance; fund classification.

DOI: 10.1504/IJPAM.2014.064383

International Journal of Portfolio Analysis and Management, 2014 Vol.1 No.4, pp.345 - 379

Received: 09 Jul 2013
Accepted: 28 Jan 2014
Published online: 30 Aug 2014 *

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