The Only Fund in Town? Geographic Segmentation in the US Mutual Fund Industry

• Author: Shane Underwood,Jesse A. Ellis
• Published date: 01 September 2018
• Date: 01 September 2018
• DOI: http://doi.org/10.1111/fima.12216

The Only Fund in Town? Geographic

Segmentation in the US Mutual

Fund Industry

Jesse A. Ellis and Shane Underwood∗

We find that mutual funds located in regions with more competing funds charge lower manage-

ment fees, but higher fees related to sales and distribution (12b-1 fees), sales loads, and other

nonmanagement fee expenses. Thereis some evidence that funds in more competitive regions have

higher total expense ratios than similar funds in less competitive regions.Our results indicate that

while increased competition drives down fund profits, it creates a negative externality by way of

increased sales expenses. Overall, our results suggest the mutual fund industry is characterized

by monopolistic competition determined at the local level.

There is some debate as to whether the mutual fund industry exhibits the characteristics of a

truly competitive market. Supporting the competitive viewpoint, Wahal and Wang (2011) find

that incumbent funds lower their fees and receive lower inflows when new funds with similar

holdings enter the market place. Alternatively, Cooper, Halling, and Yang (2015) note that there

is considerable fee dispersion among otherwise similar funds and that important product quality

characteristics, such as returns, risk, and portfolio holdings, explain less than half of the observed

dispersion in fees across funds.

The question as to whether competitive forces in the mutual fund industry are sufficient to

constrain managers from charging excessive fees is an important one as there is considerable

evidence that mutual fund investors do not sufficiently respond to product quality (performance)

or price (fees) when making their portfolio decisions (Christoffersen and Musto, 2002; Elton,

Gruber and Busse, 2004; Gil-Bazo and Ruiz-Verdu, 2009). For instance, active funds charge

higher fees and have lower performance than passive index funds (Fama and French,2010). Even

among active funds, Gil-Bazo and Ruiz-Verdu (2009) find that funds with poorer performance

actually charge higher fees than their active competitors. These facts suggest that funds engage

in monopolistic competition, whereby funds produce differentiated products (at least from the

perspective of the consumer) and consumers behave as if they have some degree of brand loyalty

and/or high search or switching costs. The fact that mutual fund flows are shown to be fairly

insensitive to poor performance supports this view (Christoffersen and Xu, 2017). In addition,

Hortac¸su and Syverson (2004) determine that despite offering the same underlying portfolio, there

is great fee dispersion among competing S&P 500 Index funds. They attribute this dispersion to

search costs and differentiation along nonportfolio fund family characteristics.

Much of this work was completed while Underwood was at the University of Alabama. We are grateful to Sergey

Chernenko, Wenhao Yang, participants at the 2014 FMA Conference, and seminar participants at the University of

Tennessee, Mississippi State University, and Baylor University for helpful comments and suggestions. All errors areour

own.

∗Jesse A. Ellis is an Associate Professor in the Poole College of Management at North Carolina State University in

Raleigh, NC. Shane Underwood is an Associate Professor in the Hankamer School of Business at Baylor University in

Wac o , TX .

Financial Management •Fall 2018 •pages 715 – 737

716 Financial Management rFall 2018

In this paper, we argue that an important dimension of fund differentiation could be the

fund’s geographic location, which could determine its likely base of potential investors, as well

as its relative set of competitors. If this is true, then geography may play an important role

in determining the fees mutual funds charge their investors. Our argument is based on the

premise that if investors exhibit a local bias in their portfolio allocation decisions, they may

disproportionately favor local versus distant mutual funds. The fact that investors exhibit a

strong bias toward investments that are located geographically close to them has been well

documented in the literature. For example,investors prefer domestic versus foreign stocks (French

and Poterba, 1991), mutual funds disproportionately investin stocks headquartered nearby (Coval

and Moskowitz, 2001), and banks are more likely to lend to local firms (Petersen and Rajan,

2002).

We hypothesize that investors’ local bias could result in some degree of geographic segmenta-

tion in the mutual fund market. Thus, the intensity of fund competition maynot only be determined

by market-wide factors, such as the total number of funds in operation, but also by local factors,

such as the number of funds that operate nearby. If investors prefer local funds and there are few

funds located nearby (e.g., Birmingham, AL), then those funds should have relativelymore local

market power than funds that are located in regions with more local competitors (e.g., Boston,

MA).

We expect that increased local market power should enable funds to earn greater profits (i.e.,

charge higher management fees) than funds operating in more crowded locations. However,

the effect of competition on the total price mutual funds charge (i.e., total expenses) is theo-

retically ambiguous. That is, the total price a producer (funds) charges consumers (investors)

reflects both the cost of producing the product, as well as the profit realized by the producer.

If greater competition forces funds to expend greater resources on marketing in order to at-

tract investors, it would raise the fund’s production costs and could, as such, raise prices for

investors.1

In a similar analysis of the US equity market, Hong, Kubik, and Stein (2008) reason that

if investors exhibit a preference for local securities, then the market for those securities could

become geographically segmented. They argue that the price of stocks headquartered in regions

with relatively few companies could be driven up by the fact that investors have few other local

choices to add to their portfolio, a phenomenon they refer to as the “only game in town effect.”

In this paper, we test for such an effect in the mutual fund industry. Using a sample of 2,682

domestic equity mutual funds from 2000 to 2015, we examine whether mutual fund prices (fees)

and quality (performance) are, in part, determined by the degree of local competition those funds

face. We define our local marketplaces using US Census Metropolitan Statistical Areas (MSAs),

although our results also hold at the state level. We measure the degree of local competition as

the total number of funds or fund families in the local area.

Webegin by documenting evidence of local bias by mutual fund investors. Our analysis follows

that of Sialm, Sun, and Zheng (2014) who document local flow comovement in the hedge fund

industry as evidence of local bias in hedge fund investment. They argue that if investors have

a local bias in their fund allocations, then flows should be partly driven by shocks to local

1There is a great deal of economic theory that suggests various scenarios whereby monopolistic competition could

lead to a positive relation between competition and prices, particularly when customers face search or switching costs

(Satterthwaite, 1979; Stiglitz, 1987; Hortac¸su and Syverson, 2004). If investors have switching or search costs (i.e.,

perhaps they havebrand loyalty or are so uninformed about the set of alternative mutual funds that it is particularly costly

for them to search for and evaluate alternativeproviders), then funds have an incentive to expend resources on advertising

and distribution activities in order to capture rents from a set of loyal investors. This process could lead to higher total

prices.