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Star Ratings and the Incentives of Mutual Funds
Author(s) -
HUANG CHONG,
LI FEI,
WENG XI
Publication year - 2020
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/jofi.12888
Subject(s) - reputation , mutual fund , incentive , fund administration , star (game theory) , business , manager of managers fund , microeconomics , actuarial science , economics , finance , fund of funds , mathematics , political science , law , mathematical analysis
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.