Mutual fund competition and stock market liquidity

We study how competition in the mutual fund industry affects the stock market and its liquidity. We argue that mutual fund families operate as multi-product firms, jointly choosing fees, performance and number of funds. We show that competition between fund families distorts the incentives to collect information and induces the families to trade off performance and number of funds. An increase in the cost of information reduces the amount of information that families collect and the fees they charge and increases the number of funds they offer. The presence of more and relatively less informed funds impacts the market, increasing liquidity and reducing volatility and prices. This allows us to use observable equilibrium conditions in the mutual fund market (i.e., fees, number of funds, performance, cost of information, investor demand) to proxy for the unobservable level of information and to relate it to stock market conditions. We test our theory using the universe of the US equity funds in the past 20 years. We identify the fund characteristics and relate them to the volatility, liquidity, cross-correlation and prices of the stocks that are held by them. We show that the fund characteristics do affect stocks in the way predicted by the model. JEL classification: G11, G12, G14.