Mutual funds and industrial organization

This dissertation studies financial product differentiation and fee competition in the mutual fund industry. It consists of three essays.; The first essay empirically measures how financial product differentiation over states of nature affects fee competition in the mutual fund industry. First, this essay develops a multinomial IV logit model with random characteristics to estimate how investors respond to mutual fund past performance. The study finds that investors not only chase last period's risk-adjusted returns, the alphas, but also respond to the last period's factor returns. In such a context, mutual fund managers can gain higher profits by excessively differentiating their portfolios in order to win and attract cash in different states of nature and thus obtain stochastic market power. The study estimates that, on average, equity mutual funds increase their annual profits by roughly 25% ({dollar}3.2billion) through financial product differentiation over states of nature.; The second essay theoretically models spatial competition in the mutual fund industry. First, using a simple "location-then-price" two-stage model, this essay shows that duopoly funds tend to differentiate their portfolios to the maximum extent possible. Second, the model is generalized to oligopoly mutual funds. Although mutual fund managers have identical information and face homogenous investors, in equilibrium, they behave strategically and choose a range of factor-loadings. The cross-section dispersion of factor loadings is related to investors' risk preferences and the probability distribution of factor returns.; The third essay analyzes the fee structures of the multi-class mutual funds using a constructed data set. The different classes of a multi-class fund have identical portfolios and the same portfolio manager(s), but different fee schedules. Several empirical results are established. First, nonlinear pricing mechanisms are widely employed in the mutual fund industry. In particular, mutual funds segment the market in two dimensions: the size of investments and the time horizon of investors. Second, consistent with the direct information sales theory (Admati and Pfleiderer (1990)), fund categories with wider dispersions in performance charge higher distribution fees. Third, mutual fund investors demonstrate self-selection behavior. Finally, the study shows that the multiple fee structure is a revenue-generating strategy for mutual funds.