An important question in financial economics is why financial intermediaries are so highly compensated, even with the intense competition between them and the uncertainty about whether they add value to investors. Whether active portfolio managers have skill and can obtain persistent positive abnormal returns has been the focus of debate in the mutual fund literature (Chevalier and Ellison, 1997, Carhart, 1997, Wermers, 2000). This has led researchers to question whether there is an opportunity for active mutual fund managers to create compensation for themselves despite the competition from other market participants. Thus far compensation received by managers has been attributed to an irrationally sluggish response by investors to mediocre performance, and the opportunistic exploitation of it by fund managers (Elton, Gruber and Busse, 2004). For instance, in the mutual fund industry investors do not withdraw funds in response to poor past performance to the same extent as they invest in response to superior performance. This asymmetry between inflows and fund performance has been documented in the results of Ippolito (1992), Sirri and Tufano (1992), and Chevalier and Ellison (1997). This evidence raises the possibility that fund complexes making acquisitions decisions may target “undervalued assets”, mutual funds with low objective-adjusted expense ratios, with the intent to increase the expense ratio and, hence, the fees the fund complex can extract from the acquisition target. However, an increase in expense ratios without a corresponding increase in returns of the target fund in the post-acquisition period should lead to a reduction in objective adjusted inflows by rational investors.

Several studies regard mutual fund shareholders as being smart investors (Gruber,1996, Zheng, 1999). For insistence, Barber, Odean, and Zheng (2005) contend that, overtime, investors have become increasingly aware of and averse to mutual fund costs. They find that investors readily avoid high front-end load and commissions costs and tolerate high operating expense costs. This occurs because front-end load fees and commissions are more obvious and salient. Consistent with this, Berk and Green (2004) present an alternative explanation where the ability to extract fees occurs as a natural consequence of learning and compensation goes to managers with investment talents. The implication of this is that if fund complexes acquire “undervalued assets” and subsequently attempt to extract compensation without a corresponding increase in benefits, investors, being smart, will “vote with their feet” by reducing their net flows to these funds in the post-acquisition period.