We build a model of mutual fund competition in which a fraction of investors ("unsophisticated")
exhibit a preference for familiarity. Funds differ both in their quality and their visibility: While
unsophisticated investors have varying degrees of familiarity with respect to more visible funds,
they avoid low-visibility funds altogether. In equilibrium, bad low-visibility funds are driven
out of the market of sophisticated investors by good low-visibility funds. High-visibility funds
do not engage ...
We build a model of mutual fund competition in which a fraction of investors ("unsophisticated")
exhibit a preference for familiarity. Funds differ both in their quality and their visibility: While
unsophisticated investors have varying degrees of familiarity with respect to more visible funds,
they avoid low-visibility funds altogether. In equilibrium, bad low-visibility funds are driven
out of the market of sophisticated investors by good low-visibility funds. High-visibility funds
do not engage in competition for sophisticated investors either, and choose instead, to cater to
unsophisticated investors. If familiarity bias is high enough, bad funds survive competition from
higher quality funds despite offering lower after-fee performance. Our model can thus shed light
on the persistence of underperforming funds. But it also delivers a completely new prediction:
Persistent differences in performance should be observed among more visible funds but not in
the more competitive low-visibility segment of the market. Using data on US domestic equity
funds, we nd strong evidence supporting this prediction. While performance differences survive
at least one year for the whole sample, they vanish within the year for low-visibility funds. These
results are not explained by differences in persistence due to fund size or investment category.
The evidence also suggests that differences in persistence are not the consequence of other forms
of segmentation on the basis of investor type (retail or institutional) or the distribution channel.
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