Are mutual fund investors paying for noise?

Lorenzo Casavecchia, Hardy Hulley

Research output: Contribution to journalArticlepeer-review

2 Citations (Scopus)

Abstract

In this study we identify an implicit noise premium in mutual fund advisory fees. We argue that idiosyncratic volatility makes it difficult for investors to estimate fund performance, resulting in investor disagreement about advisory skills. Since mutual fund shares cannot be sold short, the outcome is higher advisory fees than would be the case if advisory skills were transparent to investors. We find empirical support for this argument, in the form of a positive dependence of advisory fees on idiosyncratic volatilities, which is robust to the inclusion of other fund characteristics known to affect advisory compensation. We show that the dependence of advisory fees on idiosyncratic volatilities improves previous estimations of the fee-performance sensitivity for mutual funds. Our findings also reveal that investor sophistication reduces the dependence of advisory compensation on idiosyncratic volatility, since more sophisticated investors are less inclined to reward advisors for generating noisy returns.
Original languageEnglish
Pages (from-to)8-23
Number of pages16
JournalInternational Review of Financial Analysis
Volume58
DOIs
Publication statusPublished - 1 Jul 2018

Keywords

  • Advisory fees
  • Idiosyncratic noise
  • Short-selling constraints

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