Mutual Fund Flows and Fund's Strategic Behavior When Investors Are Inattentive

Abstract

The paper builds on a simple yet novel idea that the way investors react to the recent mutual fund performance depends largely upon the long-term historical performance of that fund. In particular, I find that investors react more actively to the fund's recent performance in case of the funds with good performance history. I show that these effects are strongest for funds which are likely to attract attentive investors such as funds having more visibility or funds with high entry loads. Next, I show that investors who are less responsive to the fund performance are also less responsive to the changes in fund fees which suggests that investor inattention rather than any other rational decision making process that explains the sluggish capital flows. I build a model which shows how the concentration of attentive investors within fund rise with the historical performance which feeds into more reactive capital flows. I provide evidence that mutual funds are aware of the varying degree of investor responsiveness and they adjust their pricing and portfolio risk to maximize the revenue.