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Mutual funds and bubbles: the surprising role of contractual incentives

Author: Dass, Nishant ; Massa, Massimo ; Patgiri, RajdeepINSEAD Area: FinanceIn: Review of Financial Studies, vol. 21, no. 1, January 2008 Language: EnglishDescription: p. 51-99.Type of document: INSEAD ArticleNote: Please ask us for this itemAbstract: This paper deals with one of the potential causes of the financial market bubble of the late 1990s: herding behavior of mutual funds. We study the relation between the incentives contained in the mutual fund advisory contracts and fund managers' propensity to ride a bubble. We show that the incentives embedded in the contract 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 pack, thus reducing their holding of bubble stocks. Therefore, during a bubble, the contractual incentives effectively induce managers to invest less in bubble stocks and more in "old-economy" stocks. We show that mutual funds with high-incentive contracts diverged from the herd and had relatively lower exposure to bubble stocks in the period prior to March 2000. The different exposure to bubble stocks significantly impacted funds' performance both before the bursting of the bubble and afterwards.
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This paper deals with one of the potential causes of the financial market bubble of the late 1990s: herding behavior of mutual funds. We study the relation between the incentives contained in the mutual fund advisory contracts and fund managers' propensity to ride a bubble. We show that the incentives embedded in the contract 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 pack, thus reducing their holding of bubble stocks. Therefore, during a bubble, the contractual incentives effectively induce managers to invest less in bubble stocks and more in "old-economy" stocks. We show that mutual funds with high-incentive contracts diverged from the herd and had relatively lower exposure to bubble stocks in the period prior to March 2000. The different exposure to bubble stocks significantly impacted funds' performance both before the bursting of the bubble and afterwards.

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