We argue that the effective price of investing in hedge funds far exceeds the headline fee rate of “2-and-20.” In a large 22-year sample of hedge funds, we find that 60% of the gains on which incentive fees are paid are eventually offset by losses. As a result, the effective incentive fee rate is 50% vis-à-vis the nominal 20% rate. The tendency of investors and managers to disinvest capital after negative returns contributes to this phenomenon by causing the crystallization of underwater fees and net losses as well as by eroding the protection intended by the high-water mark provision. (JEL D24, G11, G23, J33)Received: April 17, 2025Editor: J.

We analyze changes to mutual funds’ self-declared benchmarks using hand-collected data from funds’ prospectuses. Under existing rules, funds can freely change their benchmark indexes and, implicitly, the historical returns to which they compare their past performance. Funds exploit this loophole by adding (dropping) indexes with lower (higher) past returns, thereby materially improving the appearance of their benchmark-adjusted returns. High-fee funds, broker-sold funds, and funds experiencing poor performance and outflows are more likely to engage in this behavior. These funds subsequently attract additional flows despite continuing to underperform their peers.

We study whether industry familiarity is an advantage in stock trading by exploring the trading patterns of industry insiders in their own personal portfolios. To do so, we identify accounts of industry insiders in a large data set provided by a retail discount broker. We find that insiders trade firms from their own industry more frequently. Furthermore, they earn abnormal returns exclusively when trading own-industry stocks, especially obscure stocks (small, low analyst coverage, high volatility). In a battery of tests, we find no evidence of the use of private information. The results are most consistent with the interpretation that industry familiarity is an advantage in stock trading.

Funds investing in illiquid assets report returns with spurious autocorrelation. Consequently, investors need to unsmooth these funds’ returns when evaluating their risk exposures. We show that funds with similar investments share a common source of spurious autocorrelation not fully resolved by traditional unsmoothing methods and thereby leading to underestimation of systematic risk. Thus, we propose a generalized unsmoothing technique and apply it to hedge funds and private commercial real estate funds. Our method significantly improves the measurement of funds’ risk exposures and risk-adjusted performance, especially for highly illiquid funds. Overall, the average illiquid fund alpha is lower than previously thought.

We show that mutual fund investors rely on simple signals and likely do not engage in sophisticated learning about managers’ alpha as widely believed. Simplistic performance chasing best explains aggregate flows to the mutual fund space and flows across funds. These results hold for both actively managed and passive index funds. Empirical patterns commonly interpreted as reflecting learning about managerial skill also appear in falsification tests and are mechanical. Our results are consistent with the view that, on average, households are homo sapiens with limited financial sophistication rather than hyperrational alpha-maximizing agents, as often assumed in the literature.

We show that mutual fund ratings generate correlated demand that creates systematic price fluctuations. Mutual fund investors chase fund performance via Morningstar ratings. Until June 2002, funds pursuing the same investment style had highly correlated ratings. Therefore, rating-chasing investors directed capital into winning styles, generating style-level price pressures, which reverted over time. In June 2002, Morningstar reformed its methodology of equalizing ratings across styles. Style-level correlated demand via mutual funds immediately became muted, significantly altering the time-series and cross-sectional variation in style returns.

We show that demand effects generated by institutional frictions can influence systematic return predictability patterns in stocks and mutual funds. Identification relies on a reform to the Morningstar rating system, which we show caused a structural break in style-level positive feedback trading by mutual funds. As a result, momentum-related factors in stocks, as well as performance persistence and the “dumb money effect” in mutual funds, experienced a sharp decline. Consistent with the proposed channel, return predictability declined right after the reform, was limited to the U.S. market, and was concentrated in factors and mutual funds most exposed to the mechanism.