Working Paper: CEPR ID: DP8072
Authors: Suleyman Basak; Dmitry Makarov
Abstract: Absent much theory, empirical works often rely on the following informal reasoning when looking for evidence of a mutual fund tournament: If there is a tournament, interim winners have incentives to decrease their portfolio volatility as they attempt to protect their lead, while interim losers are expected to increase their volatility so as to catch up with winners. We consider a rational model of a mutual fund tournament in the presence of short-sale constraints and find the opposite - interim winners choose more volatile portfolios in equilibrium than interim losers. Several empirical works present evidence consistent with our model, however based on the above informal argument they appear to conclude against the tournament behavior. We argue that this conclusion is unwarranted. We also demonstrate that tournament incentives lead to differences in interim performance for otherwise identical managers, and that mid-year trading volume is inversely related to mid-year stock return.
Keywords: mutual fund tournament; portfolio choice; relative performance; risk-taking incentives; short-sale constraints
JEL Codes: D81; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| interim winners (Y60) | more volatile portfolios (G11) |
| interim losers (D52) | less volatile portfolios (G11) |
| interim performance (Y20) | portfolio volatility (G17) |
| convexity of flow-performance relationship (C61) | managers' behavior (D22) |
| interim winners (Y60) | greater volatility of year-end returns (G17) |
| interim losers (D52) | invest in riskless bonds (G12) |
| differences in interim performance (L25) | variations in portfolio risk-taking behavior (G11) |