Does Active Fee Predict Mutual Fund Flow? - Price Sensitivity of Demand for Active Management

Active fee is the ratio between the excess cost of active management over the index alternative and the fund's activity level. We suggest a simple model that explains active capital allocations in the presence of time-varying active fee. We show that investors respond in accordance with the model's prediction of a negative relationship between active fee and subsequent flows. Our findings can be interpreted as negative price elasticity of demand for active management, where one standard deviation change in active fee translates into a shift in net flow of 83.4 bps. This effect implies a 42% change in the unconditional expected yearly flow. The time-series relation is driven by both the activity level and the excess cost of active management. The result also holds after controlling for Morningstar Ratings