Familiarity and competition: The case of mutual funds

We build a model of mutual fund competition in which a fraction of investors, unsophisticated, exhibit a preference for familiarity, while sophisticated investors are free of familiarity bias. Funds differ both in their quality and their visibility. Unsophisticated investors have varying degrees of familiarity with respect to more visible funds and they avoid low-visibility funds altogether. In equilibrium, bad low-visibility funds are driven out of the sophisticated segment of the market by good low-visibility funds. High-visibility funds do not engage in competition for sophisticated investors either, and choose instead, to cater only to unsophisticated investors. If familiarity bias is high enough, bad high-visibility funds survive competition from higher quality funds despite oering lower after-fee performance. Our model can thus shed light on the persistence of underperforming funds. But it also delivers a completely new prediction: Persistent differences in performance should be observed among more visible funds but not in the more competitive low-visibility segment of the market. Using data on US domestic equity funds, we find strong evidence supporting this prediction. While performance dierences survive at least one year for the whole sample, they vanish within the year for low-visibility funds. These results are not explained by differences in persistence due to fund size or investment category. The evidence also suggests that differences in persistence are not the consequence of other forms of segmentation on the basis of investor type (retail or institutional) or the distribution channel.