Star Ratings and the Incentives of Mutual Funds |
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| Authors: | CHONG HUANG FEI LI XI WENG |
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| Affiliation: | 1. Chong Huang is at the Paul Merage School of Business, University of California, Irvine. Fei Li is at the University of North Carolina, Chapel Hill. Xi Weng is at the Guanghua School of Management, Peking University. We would like to thank Philip Bond (Editor), an anonymous Associate Editor, and three anonymous referees for insightful comments and suggestions. We also thank Jonathan Berk, Aislinn Bohren, David Brown, Shaun Davies, Vincent Glode, Richard Green, Diane Del Guercio, Jie He, David Hirshleifer, George Mailath, Moritz Meyer-ter-Vehn, Uday Rajan, Christopher Schwarz, Neal Stoughton, Zheng Sun, Yilin Wang, Lucy White, Youchang Wu, Fernando Zapatero, Lu Zheng, and audiences at the UCI Finance Seminar, UNC Finance Seminar, PKU Finance Seminar, JHU Micro Theory Seminar, CUHK Economic Theory Workshop, 2014 USC/UCLA/UCI Finance Day Conference, 2014 SITE Summer Seminar, First Summer School on Financial Intermediation and Contracting, 2016 CICF, 2017 AMES, 2019 Midwest Macroeconomics Meetings, and 2019 Shanghai Microeconomics Workshop for comments and suggestions. We thank Tan Gan for his excellent research assistance. Chong Huang thanks the CORCLR Awards for financial support. Xi Weng thanks the National Natural Science Foundation of China (Grant No. 71973002) and the Key Laboratory of Mathematical Economics and Quantitative Finance (Peking University), Ministry of Education of China for financial support. The authors contributed equally to this paper. The authors have read The Journal of Finance disclosure policy and have no conflict of interest to 2. disclose. |
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| Abstract: | We propose a theory of reputation to explain how investors rationally respond to mutual fund star ratings. A fund's performance is determined by its information advantage, which can be acquired but decays stochastically. Investors form beliefs about whether the fund is informed based on its past performance. We refer to such beliefs as fund reputation, which determines fund flows. As performance changes continuously, equilibrium fund reputation may take discrete values only and thus can be labeled with stars. Star upgrades thus imply reputation jumps, leading to discrete increases in flows and expected performance, although stars do not provide new information. |
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