Does prior performance affect a mutual funds choice of risk? Theory and further empirical evidence

Hsiu Lang Chen, George G. Pennacchi

Research output: Contribution to journalArticlepeer-review

Abstract

Recent empirical studies of mutual fund competition examine the relation between a funds performance, the fund managers compensation, and the fund managers choice of portfolio risk. This paper models a managers portfolio choice for compensation rules that can be either a concave, linear, or convex function of the funds performance relative to that of a benchmark. For particular compensation structures, a manager increases the funds tracking error volatility as its relative performance declines. However, declining performance does not necessarily lead the manager to raise the volatility of the funds 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.

Original languageEnglish (US)
Pages (from-to)745-775
Number of pages31
JournalJournal of Financial and Quantitative Analysis
Volume44
Issue number4
DOIs
StatePublished - Aug 2009

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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