Abstract: Index funds are one of the most common ways investors access financial markets and are perceived to be a transparent and low-cost alternative to active investment management. Despite these purported virtues of index fund investing and the introduction of new products and competitors, many funds remain expensive and fund managers appear to exercise substantial market power. Why do index funds have market power? We develop a novel quantitative dynamic model of demand for and supply of index funds. In the model, investors are subject to inertia, search frictions, and have heterogeneous preferences. These frictions on the demand side create market power for index fund managers, which fund managers can further exploit by price discriminating and charging higher expense ratios to retail investors. Our results suggest that the average expense ratios paid by retail investors are roughly 45\% higher as a result of search frictions and are 40\% higher as a result of inertia compared to the friction-less baseline. In our counterfactuals, we find an interaction between search frictions and inertia---inertia imposes higher (lower) costs on investors when search frictions are low (high).
Allaudeen Hameed, National University of Singapore
Harshini Shanker, London Business School
Ayako Yasuda, University of California-Davis
Abstract: We show that mutual funds report their junior stakes in startups at 43% higher valuation than model fair values that consider multi-tier capital structures of startups. The latest-issued and most senior security is worth 48% more per share than junior securities held by mutual funds, implying that mutual funds mark junior securities close to par with the senior securities. Our findings are robust to model assumptions. Identical valuations reported for dual holdings of senior and junior securities imply 37% discrepancy in implied values of the firm. Overvaluation is lower for fund families with longer experience in private startup investments, and higher for junior securities purchased in secondary transactions. Overvaluation declines after down rounds (new financing rounds with purchase prices lower than previous rounds) and near IPOs. The results are consistent with mutual funds neglecting the probability of negative outcomes in which junior securities are paid less than senior securities and overweighting successful exits where all securities convert to common equity and are paid equally.
Discussant: Sophie Shive, University of Notre Dame
Abstract: This paper investigates how household income risk influences mutual fund managers’ portfolio decisions. I provide novel empirical evidence that state-level local income shocks affect capital flows to retail mutual funds. By analyzing portfolio holdings data, I find that, consistent with the predictions of a portfolio optimization model, active fund managers hedge local income shocks by tilting their portfolios away from high local income beta stocks. Furthermore, in expectation of a higher flow to income sensitivity, active fund managers change their portfolio tilts to hedge income shocks more strongly, and vice versa. This finding reveals that fund managers’ incentive to hedge income shocks is partly driven by their flow-hedging motives. I also show that the trade-off between income hedging and local bias can help explain the local bias puzzle.
Discussant: Winston Dou, University of Pennsylvania
