Abstract
Abstract We develop a model of mutual fund manager investment decisions near the end of quarters. We show that when investors reward better performing funds with higher cash flows, near quarter‐ends a mutual fund manager has an incentive to distort new investment toward stocks in which his fund holds a large existing position. The short‐term price impact of these trades increase the fund's reported returns. Higher returns are rewarded by greater subsequent fund inflows which, in turn, allow for more investment distortion the next quarter. Because the price impact of trades is short term, each subsequent quarter begins with a larger return deficit. Eventually, the deficit cannot be overcome. Thus, our model leads to the empirically observed short‐run persistence and long‐run reversal in fund performance. In doing so, our model provides a consistent explanation of many other seemingly contradictory empirical features of mutual fund performance.
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