Abstract
We show that some mutual funds are created to exploit investor irrationality and prioritize raising short-term capital over value creation. We find that capital flows into new funds, which lack performance histories, are especially sensitive to portfolio compositions. Funds loading heavily on past winner stocks at inception attract abnormally high flows, but only until they accumulate a performance record of sufficient length. This short-term flow-boosting strategy is associated with a long-term (up to eight years) fund underperformance, suggesting that availability of managerial talent or investment opportunities were not the main motives for the fund initiation. Overall, we establish that poor mutual fund performance, a pervasive phenomenon, can result from rent seeking incentives which drive fund inceptions. This mechanism also explains proliferation of inferior funds in the cross-section.
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