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This study characterizes a systematic relationship between the diversification incentives and the market structure of the mutual funds industry with investors differentiated by their attitude towards risk. With sufficiently low competition the subgame perfect portfolio equilibrium exhibits maximal risk differentiation. With intensified competition intermediate funds, i.e., those attracting investors with intermediate attitudes towards risk, select diversified portfolios. Finally, we offer a general characterization of how imperfect competition between risk-differentiated funds will generate an equilibrium relationship between risk and expected returns.

To an increasing extent investors do not invest in individual securities one at a time. Instead investors want to combine many assets into well-diversified portfolios in order to reduce the risk of their overall investment. Institutions like mutual funds offer such services. By the end of 1999 mutual funds were estimated to manage assets in excess of those at commercial banks in the U.S. Overall equity mutual funds represented 18 per cent of all U.S. equity, by value. However, mutual funds are differentiated along several dimensions as they offer portfolios which are diversified according to different characteristics, thereby forming different market categories. In fact, the number of mutual funds in the U.S. exceeds the number of stocks traded on both the NYSE and the AMEX added together, reaching far beyond 6000 funds. Similarly, in this industry the degree of segmentation has increased, reportedly reaching around 41 different categories (see, Massa, 2000). Parallel to the expansion of the mutual fund industry the financial markets have been transformed by a frantic pace of financial innovation directed towards security design (see, for example, Allen and Gale, 1994). In light of this evidence we can conclude that diversification and differentiation represent crucial strategic instruments whereby fund managers compete for investors. In this paper we design a stylized formal model of the mutual funds industry in order to investigate the structural relationship between market structure and the incentives of mutual funds to diversify their asset portfolios. In general, the way managers of mutual funds construct their asset portfolios will affect the risk inferences drawn by investors and thereby the expected portfolio return required by these investors. In fact, the choice of riskiness incorporated in the portfolio selection might constitute an important strategic instrument with respect to the competition taking place among mutual funds. In this respect each fund manager faces a number of central strategic decisions: Should the fund concentrate on a few industries or a few geographical regions (countries) so as to exploit gains from specialization based on economics of scale with respect to, for example, monitoring as a way to create a competitive advantage for itself? Or, should the fund invest in a portfolio with maximal diversification so as to minimize the risk of its asset portfolio thereby attracting risk averse or liquidity-oriented investors who will accept a lower expected rate of return? In the present paper we build a formal model of strategic competition between mutual funds in order to analyze this tradeoff between specialization and diversification. In particular, our model makes it possible to provide answers for the following questions: How will competition between mutual funds impact on their diversification decisions? Is there a systematic relationship between the diversification incentives and market structure in the mutual funds industry? The research literature devoted to the mutual funds industry has so far presented no formal models of competition between funds with diversification as the strategic instrument in an oligopolistic sense. Nanda et al. (2000) focus on a perfectly competitive mutual fund industry with risk-neutral investors and heterogeneous managerial ability. Within such a context they demonstrate how funds differentiated by load types can separate investors with different liquidity needs. Earlier Chordia (1996) explored a monopolistic industry and demonstrated how a monopoly fund may enhance investors’ welfare. This happens because the fund is able to lower liquidity costs by diversifying across investors who face less than perfectly correlated liquidity shocks. In contrast to these contributions the present study offers a general characterization of how imperfect competition between funds generates an equilibrium relationship between risk and expected returns in the absence of heterogeneity in terms of manager abilities. An important branch of the literature on mutual fund has focused on the explanations for why we observe intertemporal persistence in the performance of the funds. For example, Khorana and Nelling (1998) offer empirical evidence of this type of persistence. Grinblatt et al. (1995) reported that 77 percent of the mutual funds were “momentum investors”, operating with a strategy of buying stock that were past winners. These authors then examined the extent to which herding and momentum investing affect the performance of the funds. Another body of analytical work has focused on the issue of what service mutual funds offer so as to motivate investors into these funds. One explanation refers to fund managers as being better informed than investors and within such an agency approach it is possible to characterize optimal compensation contracts so as to induce the fund managers to expend effort to generate information and to use it appropriately for the portfolio selections (see, for example, Dybvig et al., 1999). In contrast to the mutual fund industry a number of studies have explored the relationship between the market structure and the incentives of risk taking, in a more general sense than that of diversification exclusively, in another financial industry, namely the banking industry. Matutes and Vives (2000) have examined the consequences of imperfect competition for deposits on the risk-taking incentives of banks with a particular focus of the policy issues relevant for the banking industry. Koskela and Stenbacka (2000) focus on the relationship between market structure and risk taking in lending markets where the borrowers have access to mean-shifting investment technologies and they ask whether there is a tradeoff between competition and financial fragility. Still other studies like Broecker (1990), Gehrig (1998) and Shaffer (1998) have investigated the consequences of adverse selection resulting from the unobserved characteristics of borrowers. In the present study we construct a model of a differentiated mutual funds industry in which the funds are engaged in two-stage competition based on (i) how to diversify their asset portfolios and (ii) what fees to impose on the investors. Our study characterizes a systematic relationship between the diversification incentives and the market structure of mutual funds. With sufficiently low competition, i.e. in a duopoly, the subgame perfect portfolio equilibrium will exhibit maximal risk differentiation and the funds will choose a strategy of specialization. With intensified competition we find that intermediate funds, i.e. those attracting investors with intermediate attitudes towards risk, will select diversified portfolios. The article is organized as follows. Section 2 presents a model of a market for competition between two mutual funds. Section 3 establishes a general principle of maximal risk differentiation according to which the subgame perfect portfolio exhibits asset specialization. In Section 4 the competition is intensified through the introduction of a third fund and we demonstrate that the fund attracting investors with intermediate attitudes towards risk will select a perfectly diversified portfolio. Section 5 presents a characterization of how imperfect competition between funds differentiated by risk will generate an equilibrium relationship between risk and expected returns. Finally, Section 6 offers some concluding comments.

In light of the explosive growth of mutual funds available to investors it is extremely important to investigate the effects of market structure in the mutual funds industry on the investment behavior and risk taking of these funds. Our analysis presents a general characterization of how imperfect competition among investment funds differentiated by risk will generate an equilibrium relationship between risk and expected returns of these funds. The present study offers a first, pioneering attempt at addressing this general issue. From our analysis we are able to characterize a systematic relationship between the diversification incentives and the market structure of the mutual funds industry. With sufficiently low competition, i.e., in a duopoly, the subgame perfect portfolio equilibrium will exhibit maximal risk differentiation, because the Nash equilibrium fees are linearly increasing functions of the risk differential. With intensified competition we find that intermediate funds, i.e., those attracting investors with intermediate attitudes towards risk, will select diversified portfolios. Also our analysis has made clear that the portfolio equilibrium is not characterized by rent equalization between the funds. Instead, as the case with three competing funds has shown, the subgame perfect profits are asymmetric. Such an asymmetry typically has interesting implications for the pattern of industry entry and exit. The implications of such a phenomenon have been studied in models of vertical product differentiation by, for example, Shaked and Sutton 1982 and Shaked and Sutton 1983 and Anderson et al. (1992). It could be an interesting direction for further research to investigate the industry dynamics generated by entry and exit for industries characterized by risk differentiation like the present model. Of course, the model presented has abstracted from a number of important considerations. The model represents a partial equilibrium analysis where we have excluded investment opportunities outside of the mutual funds industry. An initial step to incorporate generalizations in such a direction would be to endow the investors with outside options the values of which are determined by the risk-return combinations offered by alternative financial assets. Such a generalization could be particularly interesting insofar as it could offer insights into whether the mutual funds industry is likely to face tougher competition from alternative assets at the upper or lower end of the risk spectrum. Further, our analysis has abstracted from agency issues associated with informational advantages of fund managers relative to investors. Inclusion of such aspects into the question of how increased competition between mutual funds affects the incentives for diversification would require a, still missing, general theory of competing pairs of principals and agents within the context of imperfectly competitive markets.