Information Loss over the Business Cycle

Abstract

The composition of the mutual fund industry changes through entry and exit over the business cycle. Entrants may on average be higher quality than exiting funds (a cleansing eect that improves welfare), but they have no returns history and so investors have less precise beliefs about their ability (an information loss effect that harms welfare). I find that the net effect of this firm turnover is negative in the short- term but turns positive as the effect of information loss decays over time. I show that older funds should optimally be subsidized during recessions to preserve their socially valuable returns history.

Reference

Patrick Coen, “Information Loss over the Business Cycle”, TSE Working Paper, n. 21-1220, May 2021.