Liquidity, Managerial Ability, and Mutual Fund Structure

Posted: 6 Oct 1997

See all articles by Vikram K. Nanda

Vikram K. Nanda

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics

M. P. Narayanan

University of Michigan, Stephen M. Ross School of Business

Vincent A. Warther

Compass Lexecon

Date Written: July 1997

Abstract

This paper provides a model that explains the structure of mutual funds. Specifically, the paper explains why funds structure as open- or closed-end funds, and why some open-end funds charge loads. In our model fund managers generate earn excess returns that, on the margin, are increasing in their ability and decreasing in the size of funds under management. Managers capture the rents from their ability by optimally setting the management fee and attracting funds from investors. Investors have stochastic liquidity needs that impose a cost on open-end funds and reduce manager's expected profits by causing the funds available for investment to deviate from an optimal level. While managers of open-end funds can charge loads to discourage investors with high anticipated liquidity needs, they need to pay a premium in the form of higher expected returns to attract the relatively scarce investors with low liquidity needs. Fund managers whose ability is known with more precision can avoid paying investors the premium by forming closed-end funds which provide investors liquidity without exposing the fund to liquidity shocks. Managers whose ability is more uncertain will prefer to form open-end funds, however, since an open-end fund will tend to be closer to an optimal size n as investors respond to new information about managerial ability by increasing or decreasing the funds under management. The model provides several empirical implications: 1) Among open-end funds, load funds are more profitable to operate than no-load funds. 2) Investors in open-end load fund earn higher returns than those in no-load open-end funds. 3) The higher the uncertainty in investor liquidity needs in the economy, the higher is the rate of return required by investors in open-end load funds. 4) Minimum loads charged by open-end funds are positively related to investor's rate of return from such funds and uncertainty in liquidity needs in the economy. 5) Closed-end fund managers are likely to be those with a well established reputation.

JEL Classification: D4, G2, G3

Suggested Citation

Nanda, Vikram K. and Narayanan, M. P. and Warther, Vincent August, Liquidity, Managerial Ability, and Mutual Fund Structure (July 1997). Available at SSRN: https://ssrn.com/abstract=11188

Vikram K. Nanda

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics ( email )

2601 North Floyd Road
P.O. Box 830688
Richardson, TX 75083
United States

M. P. Narayanan (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States
734-763-5936 (Phone)
734-936-0274 (Fax)

Vincent August Warther

Compass Lexecon ( email )

332 South Michigan Avenue
Suite 1300
Chicago, IL 60604
United States

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