RFS Advance Access originally published online on July 27, 2006
Review of Financial Studies 2008 21(5):2307-2343; doi:10.1093/rfs/hhl031
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Market Discipline and Internal Governance in the Mutual Fund Industry
ISK Vienna and Vienna University of Technology
University of Vienna
University of Vienna
Address correspondence to Josef Zechner, Department of Finance, University of Vienna, Bruennerstrasse 72, A-1210 Vienna, Austria, e-mail: josef.zechner{at}univie.ac.a.
JEL Classification: G11, G23, G30
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Abstract |
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We develop a continuous-time model in which a portfolio manager is hired by a management company. On the basis of observed 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, and the management company can fire the manager. Introducing firing rationalizes several empirically documented findings, such as the positive relation between manager tenure and fund size or the increase of portfolio risk before a manager replacement and the following risk decrease. The analysis predicts that the critical performance threshold that triggers firing increases significantly over a manager’s tenure and that management replacements are accompanied by capital inflows when a young manager is replaced but may be accompanied by capital outflows when a manager with a long tenure is fired. Our model yields much lower valuation levels for management companies than simple applications of discounted cash flow (DCF) methods and is thus more consistent with empirical observations.
A previous version of this article was circulated under the title "Mutual Fund Flows and Optimal Manager Replacement." We thank Matthew Spiegel (the editor) and an anonymous referee, who helped us improve the article considerably. We also thank Michael Brennan, Engelbert Dockner, Robert Elliot, Marcin Kacperczyk, Anthony Lynch, Kristian Miltersen, Neal Stoughton, Suresh Sundaresan, Russ Wermers, Stefan Zeisberger, participants of seminars at the University of Vienna, University of Tübingen, City University London, Lancaster University, University of Cologne, Norwegian School of Economics and Business Administration, UCLA, UC Berkeley, Stanford University, HEC Paris, participants of the European Finance Association 2004 meeting in Maastricht, the German Finance Association 2004 meeting in Tübingen, and the American Finance Association 2006 meeting in Boston for valuable suggestions and comments. Youchang Wu and Josef Zechner gratefully acknowledge the financial support by the Austrian Science Fund (FWF) under grant SFB 010 and by the Gutmann Center for Portfolio Management at the University of Vienna.