Market Discipline and Internal Governance in the Mutual Fund Industry∗

This paper develops a continuous-time model in which a portfolio manager is hired by a management company. Based on past portfolio returns, all agents update their beliefs about the manager’s skills. In response, investors can move capital into or out of the mutual fund, the portfolio manager can alter the risk of the portfolio and the management company can replace the manager. We examine the resulting interaction between internal governance and product market discipline and generate a rich set of predictions on mutual fund flows, portfolio risk, portfolio manager turnovers, and the value of the management company. In particular we derive the optimal manager replacement rule of the fund management company and show how it is influenced by the uncertainty about managerial skills, manager tenure and other model parameters. For reasonable parameterizations, the firing of a portfolio manager is accompanied by a capital inflow and a portfolio risk reduction. If the belief about managerial skills becomes more precise over time, then the firing threshold increases with manager tenure. Our model also shows how fund inflows are related to fund performance, fund size, and uncertainty about managerial skills. While we find that fund size tends to increase with manager tenure, the value of the management company as a percentage of assets under management tends to decrease. The portfolio management industry has undergone dramatic growth in the last few decades, thereby also generating an increasing interest among regulators and academics. The question how to ensure efficient governance of delegated portfolio management has attracted particular attention. Most theoretical models have addressed this question using the standard principal-agent paradigm, characterizing the optimal contracts that alleviate the agency problem between fund investors and managers.1 Several empirical studies have investigated the effectiveness of incentive fees2 and, in a somewhat different vein, the role of funds’ boards of directors in controlling agency costs.3 This paper takes a broader view of the governance mechanisms in the portfolio management industry by explicitly taking into account the role of the product market. A key characteristic of the mutual fund industry is that fund investors are at the same time consumers. The open-end structure of mutual funds allows individual investors to “fire” the fund manager by withdrawing their money whenever they feel dissatisfied with the investment management services he provides. This not only disciplines the manager directly, as pointed out by Fama and Jensen (1983), but also gives the management company strong incentives to fire underperforming managers in order to avoid losing market share. On the other hand, the fund’s internal governance actions, such as the firing of an underperforming manager, will also have an impact on investors’ capital allocation. We formalize the product market discipline via fund flows and the internal manager replacement decision simultaneously in a fully-dynamic framework. Our model shows that the interplay between these two alternative governance mechanisms is the key to understand many phenomena observed in the mutual fund market. In our model, the portfolio manager may have some stock picking ability that generates an expected rate of abnormal return by taking idiosyncratic risks. However, active portfolio management exhibits a diseconomy of scale, as introduced by Berk and Green (2004). Furthermore, the manager’s ability to manage a specific fund is not known either to the management company, to the fund investors or to the manager himself. All agents in the model only know a common prior distribution of the ability and keep updating their beliefs using the 1See, for example, Stoughton (1993), Heinkel and Stoughton (1994), Admati and Pfleiderer (1997), Das and Sundaram (2002), Ou-Yang (2003). 2See, for example, Elton, Gruber, and Blake (2003). 3See, for example, Tufano and Sevick (1997) for the case of open-end funds and Guercio, Dann, and Partch (2003) for the case of closed-end funds.