Competitor Scale and Mutual Fund Behavior

I study the effects of competition on the investment behavior and performance of active mutual funds. I find that funds respond to increased competitor scale by curtailing costly active management. To establish causality, I exploit quasi-exogenous variation in fund flows created by a natural experiment---the 2003 mutual fund scandal. Funds whose competitors were the most affected by the scandal expand active management and perform better after the scandal. Interpreting the findings through the lens of models of decreasing returns to scale indicates information asymmetry between fund managers and outside investors.