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Does Prior Performance Affect a Mutual Fund’s Choice of Risk? Theory and Further Empirical Evidence

Published online by Cambridge University Press:  01 August 2009

Hsiu-lang Chen  and
George G. Pennacchi
Hsiu-lang Chen
Affiliation:
College of Business Administration, University of Illinois at Chicago, 601 S. Morgan St., Chicago, IL 60607. hsiulang@uic.edu
George G. Pennacchi
Affiliation:
College of Business, University of Illinois at Urbana-Champaign, 515 E. Gregory Dr., Champaign, IL 61820. gpennacc@illinois.edu
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Abstract

Recent empirical studies of mutual fund competition examine the relation between a fund’s performance, the fund manager’s compensation, and the fund manager’s choice of portfolio risk. This paper models a manager’s portfolio choice for compensation rules that can be either a concave, linear, or convex function of the fund’s performance relative to that of a benchmark. For particular compensation structures, a manager increases the fund’s “tracking error” volatility as its relative performance declines. However, declining performance does not necessarily lead the manager to raise the volatility of the fund’s return. The paper presents nonparametric and parametric tests of the relation between mutual fund performance and risk taking for more than 6,000 equity mutual funds over the 1962 to 2006 period. There is a tendency for mutual funds to increase the standard deviation of tracking errors, but not the standard deviation of returns, as their performance declines. This risk-shifting behavior appears more common for funds whose managers have longer tenures.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 44 , Issue 4 , August 2009 , pp. 745 - 775
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2009

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