Mutual Fund Portfolio Choice in the Presence of Dynamic Flows∗

We analyze the implications of the widely used fixed fraction of funds fees on a mutual fund manager’s portfolio decisions. In our model, a log utility investor is allowed to dynamically allocate capital between an actively managed mutual fund and a locally riskless bond. The optimal fund portfolio is shown to be the one that maximizes the market value of the fees received, and is independent of the manager’s utility function. The presence of dynamic flows induces “flow hedging” portfolio distortions on the part of the fund, even though the investor is myopic. We predict a positive relationship between a fund’s proportional fee rate and its volatility. This is a consequence of higher fee funds holding more extreme equity positions. However, the overall dollar amount of equity held by a fund can be independent of the fee rate. While both the fund portfolio and the investor’s trading strategy depend on the proportional fee rate, the equilibrium value functions do not. Implications related to the measured performance-fundflow relationship and its dependence on the fee rate are derived. Finally, we show that our results hold even if in addition to trading the fund and the bond the investor is allowed to directly trade some of the risky securities, but not all. JEL Classification Numbers. G11, G12, G13, G23, D81.