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RFS Advance Access published online on July 24, 2007
Review of Financial Studies, doi:10.1093/rfs/hhm033
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Copyright © The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies.

Mutual Funds and Bubbles: The Surprising Role of Contractual Incentives

Nishant Dass
INSEAD, France

Massimo Massa
INSEAD, France

Rajdeep Patgiri
INSEAD, France

Address correspondence to Massimo Massa, INSEAD, Finance Department, Boulevard de Constance, 77300 Fontainebleau, France, Tel: +33 1 6072 4481, Fax: +33 1 6072 4045, or e-mail: massimo.massa{at}insead.edu

JEL: G23, G30, G31, G32


  Abstract

This article studies one of the potential causes of the financial market bubble of the late 1990s: the herding behavior of mutual funds. We show that the incentives contained in the mutual funds' advisory contracts induce managers to overcome their tendency to herd. We argue that investing in bubble stocks amounts to herding and contracts with high incentives induce managers to diverge from the herd, thus reducing their holding of bubble stocks. The differential exposure to bubble stocks significantly impacted the funds' performance both in the period prior to March 2000, as well as afterwards.

We thank Franklin Allen, Markus Brunnermeier, Andrew Ellul, Gur Huberman and Maureen O'Hara, an anonymous referee, as well as participants at the RFS-IU Conference on the Causes and Consequence of Recent Financial Market Bubbles for stimulating comments, and William Fisk and Sriram Ganesan of INSEAD Financial Data Center for their invaluable help with the name-recognition algorithm. All remaining errors are our own.


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