The Relative Impact of Different Classification Schemes on Mutual Fund Flows

Abstract

The US mutual fund industry experienced tremendous growth during the past two decades. In November 2001 there were 8,282 mutual funds controlling over US$6.9 trillion dollars in assets, which by far exceeds 665 funds with US$241.4 billion in assets in 1981 (Investment Company Institute, 2001). With so many funds around, investors face a difficult task of selecting a fund with the desired risk and performance profile. Mutual fund categories composed of funds with a similar investment approach help investors to simplify their decision problem. Investors often first choose the category that suits their preferences and then select the best fund in that category, based on fund performance and/or other fund characteristics (see, for example, Kim, Shukla and Tomas, 2000). This investor behavior results in a specific structure of mutual fund flows, which depends on a fund’s relative performance within its category. As a consequence, the classification system also influences the incentives of fund managers, whose compensation is usually based on a percentage of fund assets (see, for example, Khorana, 1996). Given that top performers in a category attract most of the inflows, fund managers have an incentive to maximize their performance relative to other funds in the same category. This may not be consistent with their shareholders’ interests.