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Chapter 8. Mutual Funds: Performance > Tournaments and Temptations

Tournaments and Temptations

A combination of the compensation structure of mutual fund companies and mutual fund investor behavior causes a strange incentive system for mutual funds. This behavior is not typically in the best interests of mutual fund investors. First, mutual fund companies usually receive a fixed percentage of assets under management (frequently 1% of assets annually). A mutual fund with $100 million in assets will reap $1 million in management fees. This arrangement creates the incentive to maximize the size of the mutual fund being managed. The second effect is the tendency for investors to reward high past performance by providing these winners with new investment money. Alternatively, punishment of the poor performers is not as great. That is, the rewards are greater than the punishments in magnitude.

Alternatively, the relationship between mutual fund performance and new investment flow is not linear. The relationship is different for funds that have performed well and those funds that have performed poorly. This is especially true for newer and smaller mutual funds. A young mutual fund that has underperformed the S&P 500 Index by 7% in a given year can expect to lose about 25% of its assets from investors leaving the fund.[14] However, a fund that has underperformed by 20% can also expect an outflow of 25%. The penalty to the mutual fund company for poor performance is about the same as the penalty for really bad performance. On the other hand, the fund that matches the market can expect new inflows of money about equal to 15% of its current assets. The fund that the beats the market by 5% or 10% can expect an inflow of new money that represents 30% or 55% of its assets respectively.


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