On the Consequences of Mutual Fund Tournaments

Abstract

We analyze the implications of the tournament-like competition in the mutual fund industry for shareholder welfare using a framework that addresses both (a) the risk taking incentives, and (b) the effort incentives facing fund managers. We compare the ex ante shareholder utility under two competing regimes: (a) a tournament regime characterized by future fund flows accruing to the winner fund, and (b) a no-tournament regime in which future flows are not sensitive to past performance. Our analysis suggests that mutual fund tournaments can be beneficial when the informational costs and the cash flow sensitivity to past performance are moderate. Using monthly as well as daily data for a sample of domestic stock funds, we present empirical evidence consistent with the key predictions of our theoretical model.