BFS 2002

Contributed Talk

We analyze the implications of a fixed fraction of assets under management fee, the most commonly used fee by mutual funds, on portfolio choice decisions in a continuous time model. In our model, the investor has a log utility function and is allowed to dynamically allocate his capital between an actively managed mutual fund and a money market account. The optimal fund portfolio is shown to be the one that maximizes the market values of the fees received, and is independent of the manager's utility function. The presence of dynamic flows induces "flow hedging" on the part of the fund, even though the investor is log. We predict a positive relationship between a fund's proportional fee rate and a fund's volatility. This is a consequence of higher fee funds holding more extreme equity positions. However, the overall dollar amount of equity held by a fund can be independent of the fee rate, as a higher fee also implies that investors allocate a smaller fraction of their wealth to the fund. While both the fund portfolio and the investor's trading strategy depend on the proportional fee, the equilibrium value functions do not. Finally, we show that our results hold even if in addition to trading the fund and the money market account the investor is allowed to directly trade some of the risky securities, but not all.