In this section, I test both hypotheses.
5.1. Hypothesis 1: The Impact of Competition on Marketing Expenses
In this section, I test the impact of competition on the marketing expenses of mutual funds. The hypothesis is that fund marketing expense decreases with the competition.
I use annual fund 12b1 fees as a proxy for the marketing expenses. The Security and Exchange Commission (SEC) website defines ‘12b1 fees’ as fees paid by the fund out of fund assets to cover distribution expenses and sometimes shareholder service expenses. It gets its name from the SEC rule that authorizes a fund to pay them. This rule permits a fund to pay distribution fees out of fund assets only if the fund has adopted a plan (12b-1 plan) authorizing their payment. “Distribution fees” include fees paid for marketing and selling fund shares, such as compensating brokers and others who sell fund shares, as well as paying for marketing, such as the printing and mailing of prospectuses to new investors and the printing and mailing of sales literature.
I run the following OLS regression for the five competition market segments.
where
rank4
_h is an indicator variable for the reference competition segment, which takes on the value of one if the fund is operating in the lowest quintile competitive sector and zero otherwise.
rank3
_h is an indicator variable which takes on the value of one if the fund is operating in the second lowest competitive sector and zero otherwise, and so on.
rank0
_h is an indicator variable which takes on the value of one if the fund is operating in the highest competitive sector and zero otherwise.
Fund Performance is the past one-year fund holding period return.
Log (
Fund Age) is the natural logarithm of the
fund age.
Log (
Total Net Asset) is the natural logarithm of fund total net assets
. Return Volatility is the monthly standard deviation of the fund returns, calculated over the previous 12 months.
Fund Flow is the new money flow into the fund, calculated over the previous 12-month period (see
Section 3 for details).
Turnover Ratio is the annual turnover ratio of the fund.
Log (
Family Net Asset) is the natural logarithm of total net assets of the fund family.
The results of this regression are reported in
Table 3. It can be seen that the coefficient on the highest competitive sector (
rank0
_h) is negative and significant at the 5% level. That is, a fund operating in the highest competitive sector is likely to spend about four basis points less in marketing, compared to a fund operating in the lowest competitive sector. This is economically significant, given that the average
12b1 fees in the whole sample is about 60 basis points. Thus, mutual funds operating in more competitive sectors seem to spend less on marketing related activities, compared to mutual funds operating in the less competitive sectors.
3The coefficient on past performance is negative and statistically significant at the 5% level. Marketing expenses seem to increase when past performance decreases. This may appear as efforts to minimize redemptions after adverse performance outcomes. The age of a fund, included as the natural logarithm of the age to address non-linearity, has an insignificant relation with marketing expenses. The coefficient on the natural logarithm of fund total net asset is negative and significant at the 1% level. This means that larger funds tend to spend less on marketing. This may be because larger funds are already visible in the market due to their size. The coefficient on return volatility is statistically insignificant. Fund flow has a negative and statistically significant (at the 1% level) coefficient, which is intuitive—the need for marketing decreases with higher flow. Turnover ratio has a negative and statistically significant (at the 1% level) effect on marketing expenses. It can also be seen that marketing expenses go up with fund family size. That is, funds in larger families have a higher budget for marketing and distribution.
There may be an alternate reason why fees decrease with the competition. One can think of mutual funds as firms providing various products for a fee. Then the lower fees in the higher competitive sectors could be explained by mark-downs by the funds due to competitive pressure from other funds in the market. This argument may be valid for the total fees charged by the funds. However, here the considered fees are charged for marketing and distribution.
To explore this further, I study the
non-
12b1 expenses (i.e., the
total expense ratio—
12b1 fees) of the funds. I use this expense as the dependent variable (instead of
12b1 fees) in Equation (1) and estimate the coefficients. Columns 1 and 2 in
Table 4 report the results. I find that
non-
12b1 expenses actually increase with the competition. That is, a fund operating in the highest competitive sector is likely to charge 8 basis points more in
non-
12b1 expenses (statistically significant at the 1% level), compared to a fund operating in the lowest competitive sector.
I estimate Equation (1) again with
total expense ratio as the dependent variable. Columns 3 and 4 in
Table 4 report the results. I find that the
total expense ratio (which consists of both
12b1 fees and
non-
12b1 expenses) also increases with the competition.
Thus, it can be seen that lower 12b1 fees in the higher competitive sectors are not explained by mark-downs by the funds due to competitive pressure from other funds in the market.
To sum up, the evidence shows that competition has an adverse impact on marketing expenses. This is not because funds mark-down their fees with competition, but rather because with higher competition, each fund’s chance of making it to the top diminishes, which adversely affects its expected new investments (due to the convex nature of the new investments, only the top-performing funds can attract significant new investments) and hence funds respond by decreasing marketing expenses.
5.2. Hypothesis 2: The Impact of Competition on Marketing Expenses of Top-Performing Funds
In this section, I test the impact of competition on the marketing expenses of top-performing funds. As discussed earlier, I expect the impact of competition to be stronger for the top-performing funds compared to the rest. That is, top-performing funds will decrease their marketing expenses more as a response to competition compared to other funds.
I divide the funds into 5, 10, and 20 performance categories according to their past performance and estimate Equation (1) separately for the top quintile, top decile, and top five percentile fund groups. The results are reported in columns 1 and 2, columns 3 and 4, and columns 5 and 6 of
Table 5 respectively.
It can be seen that the coefficient on the most competitive market dummy variable (rank0_h) is negative and statistically significant (at the 5% level) in all three regressions. In columns 1 and 2, I find that a top quintile fund operating in the most competitive segment spends about five basis points less compared to a top quintile fund operating in the lowest competitive sector. Similarly, in columns 3 and 4, I find that a top decile fund operating in the most competitive segment spends about seven basis points less compared to a top quintile fund operating in the lowest competitive sector. Lastly, from columns 5 and 6, I find that a top five percentile fund operating in the most competitive segment spends about 9.5 basis points less compared to a top quintile fund operating in the lowest competitive sector. Thus, I find that the effect of competition on the marketing expense of top five percentile funds is almost double the magnitude of that on top quintile funds. This supports Hypothesis 2. Top-performing funds spend more money on marketing while operating in less competitive sectors to grab the attention of the investors (to gain a larger portion of the next period’s investments). This effect is stronger for them compared to non-top-performing funds.