Market Discipline and Internal Governance in the Mutual Fund Industry

We develop a continuous-time model in which a portfolio manager is hired by a management company. On the basis of observed portfolio returns, all agents update their beliefs about the manager’s skills. In response, investors can move capital into or out of the mutual fund, and the management company can fire the manager. Introducing firing rationalizes several empirically documented findings, such as the positive relation between manager tenure and fund size or the increase of portfolio risk before a manager replacement and the following risk decrease. The analysis predicts that the critical performance threshold that triggers firing increases significantly over a manager’s tenure and that management replacements are accompanied by capital inflows when a young manager is replaced but may be accompanied by capital outflows when a manager with a long tenure is fired. Our model yields much lower valuation levels for management companies than simple applications of discounted cash flow (DCF) methods and is thus more consistent with empirical observations.