Numerous papers provide evidence that actively managed mutual funds underperform passive index funds. However, these papers do not answer the question of whether or not the mutual fund manager could do better if he had the right incentives or whether or not he believes in his strategy and wrongly perceives his performance. This paper tries to shed light on mutual fund managers' objectives by examining whether or not performance responds to changes in incentives. More specifically, we look at a change in the Morningstar rating system from very coarse to very refined categories that happened in 2002. Because Morningstar rates on a curve, the size of the category a mutual fund manager ends up in should have different implications for his incentives or returns to effort depending on whether he is skilled or not. Because Morningstar ratings have the power to move money, this quasi-exogenous variation in a mutual fund manager's incentives should be reflected in his subsequent performance and rating if he can respond and improve. Moreover, we look at whether the mutual fund manager tends to improve his performance by eliminating underperformance rather than building overperformance.
Huang, Xing and Michaela Pagel. "Starring on a Curve: Are Mutual Fund Managers Responding to Incentives?" Columbia Business School, 2016.
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