Dynamic Setting of Distribution Fees in the US Mutual Fund Industry

The distribution strategies of mutual funds directly or indirectly affect both their growth and their revenues. The extent of resources dedicated by a fund to its distribution channel(s) is therefore an important strategic decision. For a sample of US diversified equity mutual funds in the period from 1994 to 2007, we analyze the distribution fees and their components (12b-1 fees and loads) with the aim to identify their economic determinants. In particular, we examine the temporal and cross-sectional relation between distribution fees and past performance, and show that past performance is an important determinant of distribution fees. Our subsequent analysis of the relation between flows and performance supports the hypothesis that management companies strategically adjust their distribution fees in response to reported returns in an attempt to influence future net money flows. We highlight that this strategic behavior is particularly concentrated in the broker-sold segment of funds and, quite surprisingly, among poor performing funds. We suggest that poorly performing funds that use their distribution channels intensively to market improvements in performance experience increased net flows, even if these improvements are merely ameliorated bad performance. Finally, we show that the higher flow benefit enjoyed by poorly performing funds occurs only when an increase in distribution fees is accompanied by a simultaneous decrease in management expenses, which suggests that investors do pay attention to the total cost of investment. Our results also show that mutual funds are always penalized by investors for raising both of these fees simultaneously. This phenomenon is furthermore amplified in the case of funds with good past performance results