Market Discipline and Internal Governance in the Mutual Fund Industry

Why Does Mutual Fund Performance Not Persist? The Impact and Interaction of Fund Flows and Manager Changes

“…Thus, while winner funds suffer from fund inflows irrespective of what happens to the manager, the performance of loser funds is only affected when both mechanisms operate together. Further, we confirm the prediction in Dangl et al (2008) that, prior to a manager change, fund risk increases, but falls post-replacement.…”

“…For loser funds, as predicted by Dangl et al (2008), we also detect a strong interaction effect between both mechanisms. Manager changes, interpreted as an "internal governance" mechanism, and outflows, treated as an "external governance" mechanism, reinforce each other and the combined effect is a 0.16 percentage points per month (1.92 percentage points per annum) higher risk-adjusted performance for loser funds experiencing both forms of governance relative to funds experiencing neither.…”

“…Hence, manager changes appear to contribute towards rectifying negative performance persistence. Dangl et al (2008) develop a theoretical model of the mutual fund industry in which poorly performing managers are subject to both external governance through market discipline with investors withdrawing funds, and internal governance in the form of manager replacement.…”

“…1 Two alternative explanations for the lack of long-term persistence are fund flows (Berk and Green, 2004) and manager changes (Khorana, 1996(Khorana, , 2001Dangl, Wu and Zechner, 2008). In this paper, we investigate how far these two "equilibrating mechanisms" 2 explain mean reversion in mutual fund performance and whether they interact as substitutes or complements.…”

“…With loser funds, the Dangl et al (2008) model predicts that the internal (termination of a manager contract) and external (investors withdraw funds) governance mechanisms are potential substitutes. If the manager has been replaced, investors will no longer see any reason to withdraw money and instead will remain invested, waiting for a performance reversal.…”