Financial Product Differentiation and Fee Competition in the Mutual Fund Industry

This paper studies how and how much the mutual fund industry increases its fees by differentiating products over the state of nature. To avoid head-to-head competition, mutual fund managers hold different portfolios which yield distinct returns and become star funds alternatively in different market situations. This enables mutual funds to obtain stochastic monopoly power and on average charge higher fees than otherwise. To emperically test this idea, this paper develops a structural model — a multinomial IV logit model with random characteristics. The model is easier to implement than the random coefficient (mixed logit) model, but yields ownand cross-price elasticities for financial products that are as sensible. The paper estimates that, on average, equity mutual funds increase their profits by roughly 30% ($2.2 bn) through this novel form of financial product differentiation. In terms of social welfare, there exists excess entry in the mutual fund industry assuming free-entry with fixed entry costs. I am deeply indebted to John Shoven and Tim Bresnahan for their invaluable advice and encouragement. In addition, I am grateful to Eric Zitzewitz and Patric Bajari for their inspiring comments. I have also benefitted from discussions with Takeshi Amemiya, Darrell Duffie, Ming Huang, Xiaowei Li, Jiaping Qiu, Barr Rosenberg, TomMead, Kenneth Reid, and Neng Wang. All errors are my own.