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We identify for the first time the crucial role played by idiosyncratic risk as a determinant of performance persistence, flow-performance sensitivity and management fees charged to fund shareholders. Using a sample of US equity mutual funds, we show that high idiosyncratic volatility indirectly captures the aggressiveness of fund investment strategies. We document that funds characterized by high idiosyncratic risk exhibit high probabilities of transitioning into the tails of the performance distribution. In particular, these high transition probabilities in performance cause funds characterized by high idiosyncratic risk to jump more frequently from one tail of the performance distribution to the other, making them appear as if they do not significantly underperform – as opposed to funds with low levels of idiosyncratic risk. Consistent with the model of Berk and Green (2004), we argue that idiosyncratic risk is a confusing factor and significantly compromises investors’ ability to clearly quantify managerial skills. Since investors learn about managerial abilities from past returns and chase performance accordingly, we should expect high noise in performance to reduce the precision of investors’ priors about these abilities. As a result, in the presence of switching costs and search costs, investors may optimally choose to wait to receive a better signal before (re-) allocating their capital. We document in fact that the sensitivity of flows to performance significantly and monotonically plunges for those funds engaging in high idiosyncratic risk, irrespective of their performance rankings. We also illustrate that funds with high idiosyncratic noise are relatively small (but not necessarily young) funds, with intensive portfolio rebalancing, which necessarily translates into higher management fees. Finally, we prove that when funds set their management fees, idiosyncratic risk is the determining factor, not performance, and that the previously-documented negative relationship between fees and performance does not survive after controlling for idiosyncratic noise.

The Effect of Idiosyncratic Risk on Mutual Fund Flows and Management Fees