Ebook Does Prior Performance Affect A Mutual Fund’s Choice Of Risk? Theory And Further Empirical Evidence
As mutual fund investing has grown, the management of mutual funds has come under closer scrutiny by financial economists. One strand of research examines potential agency problems between a mutual fund’s shareholders and its portfolio manager. Several studies investigate whether a manager might unnecessarily shift the fund’s risk in response to changes in its performance relative to other funds. This behavior is linked to the way the manager is compensated and to the actions of mutual fund investors. The manager’s compensation depends on her success in generating flows of new investments into the fund, while mutual fund investors “chase returns” by channeling investments into funds with better relative performance. This creates a situation described as a mutual fund “tournament” where portfolio managers compete for better performance, greater fund inflows, and, ultimately, higher compensation.
Inflows rise nonlinearly with a fund’s relative performance. Numerous studies document that mutual funds with the best recent performance experience a lion’s share of new inflows, but poorly performing funds are not penalized with sharply higher outflows. If the fund manager’s compensation rises in proportion to the fund’s inflows, this convex performance - fund flow relation produces a convex performance - compensation structure. Research, such as Sirri and Tufano (1998), notes that such compensation is similar to a call option, providing an incentive for a manager to raise the risk of the fund’s relative returns and increase the option’s value. To empirically test for the presence of this risk-taking incentive, studies including Chevalier and Ellison (1997), Brown, Harlow, and Starks (1996), and Busse (2001) examined the risk-taking behavior of a cross-section of mutual funds for which this incentive is predicted to differ.
The current paper adds to this mutual fund tournament literature by providing new theoretical and empirical insights into risk-taking by mutual funds. First, it models the optimal intertemporal portfolio strategy of a mutual fund manager that faces the competitive tournament environment assumed by recent empirical work. Explicit solutions for this manager’s portfolio allocation are derived when her utility displays constant relative risk aversion and compensation is either a concave, linear, or convex function of the fund’s relative calendar-year performance.
The model shows that when the penalty for poor performance is limited so that the manager’s total compensation can never fall to zero, then the fund manager chooses to deviate more from the benchmark portfolio as the fund’s relative performance declines. In other words, when a fund is performing poorly it displays more “tracking error” than when it performs relatively well. However, it is not necessarily true that an under-performing fund chooses to raise the volatility (standard deviation) of its returns.
This model result is important because almost all empirical studies that have tested for tournament risk-shifting have analyzed fund risk measures other than tracking error. Most commonly, empirical research has tested for whether under performing funds increase the standard deviation of their total returns, rather than the standard deviation of their tracking errors. The most comprehensive of these studies conclude that there is no evidence for tournament behavior. However, based on our model’s insights, we argue that this conclusion may be unwarranted because it is based on tests that have employed risk measures that are inappropriate for examining the tournament hypothesis.
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