Smart Fund Managers? Stupid Money?

We develop a theoretical model of a mutual fund manager’s investment decision that incorporates three well-known observations: (i) past fund performance influences subsequent net fund inflows; (ii) fund manager compensation rises with total assets under management; (iii) trading has short-run price impacts. These observations provide fund managers the incentive to distort investment of new cash inflows toward stocks in which the fund holds larger positions. We show that this leads to the empirically observed short-run persistence and long-run reversal in fund performance. It also explains why mutual funds tend to be relatively undiversified and appear to exhibit clairvoyant stock selection.