Familiarity and Competition: The Case of Mutual Funds

Ariadna Dumitrescu () and Javier Gil-Bazo

No 815, Working Papers from Barcelona School of Economics

Abstract: We build a model of mutual fund competition in which a fraction of investors ("unsophisticated") exhibit a preference for familiarity. Funds differ both in their quality and their visibility: While unsophisticated investors have varying degrees of familiarity with respect to more visible funds, they avoid low-visibility funds altogether. In equilibrium, bad low-visibility funds are driven out of the market of sophisticated investors by good low-visibility funds. High-visibility funds do not engage in competition for sophisticated investors either, and choose instead, to cater to unsophisticated investors. If familiarity bias is high enough, bad funds survive competition from higher quality funds despite offering lower after-fee performance. Our model can thus shed light on the persistence of underperforming funds. But it also delivers a completely new prediction: Persistent differences in performance should be observed among more visible funds but not in the more competitive low-visibility segment of the market. Using data on US domestic equity funds, we find strong evidence supporting this prediction. While performance differences survive at least one year for the whole sample, they vanish within the year for low-visibility funds. These results are not explained by differences in persistence due to fund size or investment category. The evidence also suggests that differences in persistence are not the consequence of other forms of segmentation on the basis of investor type (retail or institutional) or the distribution channel.

Keywords: familiarity bias; competition; mutual funds; performance persistence (search for similar items in EconPapers)
JEL-codes: G2 G23 (search for similar items in EconPapers)
Date: 2015-03
New Economics Papers: this item is included in nep-com and nep-fmk
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Working Paper: Familiarity and competition: the case of mutual funds (2015)
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