Mutual Funds Apart from the Crowd

Abstract

We construct measures of mutual fund uniqueness using cluster analysis of fund returns. We find funds that are more unique have higher total expense ratios, mainly due to their higher management fees. As the fund uniqueness increases, the gap in net performance widens between funds with above-median past performance and those with below- or at-median past performance. Fund uniqueness significantly reduces the sensitivity of fund flows to past performance, and increases performance persistence, especially when funds perform poorly. Since unique funds are more difficult to evaluate, these results support the prediction that higher search costs in the asset management markets lead to higher fees and larger outperformance by informed managers. They also suggest that higher costs of performance evaluation and the lack of close substitutes reduce the sensitivity of fund flows to performance and increase the convexity in the flow-performance relation, which may in turn increase performance persistence, especially the persistence of poor performance.