Conflicting incentives: why do mutual fund managers decide to be active?

Abstract

Many investors make their investment decisions based on other factors than pure risk-return. Mutual fund managers have conflicting incentives to seek excess returns and to avoid risks. I study a large sample of 28640 US year-fund observations and find that active equity funds with an explicit marketing and distribution plan are less active, as measured by the active share, and are significantly more likely to closet index. I find evidence that institutional investors are better at recognizing closet indexing, but fail to find that institutional investors can better recognize value-adding active management.