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Are mutual fund investors paying for noise?

Lorenzo Casavecchia and Hardy Hulley

International Review of Financial Analysis, 2018, vol. 58, issue C, 8-23

Abstract: In this study we identify an implicit noise premium in mutual fund advisory fees. We argue that idiosyncratic volatility makes it difficult for investors to estimate fund performance, resulting in investor disagreement about advisory skills. Since mutual fund shares cannot be sold short, the outcome is higher advisory fees than would be the case if advisory skills were transparent to investors. We find empirical support for this argument, in the form of a positive dependence of advisory fees on idiosyncratic volatilities, which is robust to the inclusion of other fund characteristics known to affect advisory compensation. We show that the dependence of advisory fees on idiosyncratic volatilities improves previous estimations of the fee-performance sensitivity for mutual funds. Our findings also reveal that investor sophistication reduces the dependence of advisory compensation on idiosyncratic volatility, since more sophisticated investors are less inclined to reward advisors for generating noisy returns.

Keywords: Advisory fees; Idiosyncratic noise; Short-selling constraints (search for similar items in EconPapers)
JEL-codes: C72 D58 D83 G11 G12 G23 (search for similar items in EconPapers)
Date: 2018
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