Difference in interim performance and risk taking with short-sale constraints

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 midyear trading volume is inversely related to midyear stock return.

Does past performance affect mutual fund tracking error in Taiwan?

“…Subsequently, using US fund data from 1976 to 2001, Goriaev et al (2005) confirmed the conclusion of Busse (2001). Furthermore, Basak and Makarov (2012) considered a rational model of a mutual fund tournament with constraints on shortselling and found that interim winners select more volatile portfolios than interim losers. They also demonstrated that tournament incentives influence interim performance for otherwise identical managers, and that mid-year trading volume is inversely related to mid-year stock return.…”

“…For the eight models, previous studies obtain the following inferences regarding the regression coefficients: a 2 , β 1 , β 2 and δ 1 . That is, a 2 > 0 in Chen and Pennacchi (2009); β 1 < 0 and δ 1 > 0 in Brown et al (1996), Chevalier and Ellison (1999), Chen and Pennacchi (2009), Pennacchi and Rastad (2011) and Basak and Makarov (2012); β 1 ¼ 0 and δ 1 ¼ 0 in Renneboog et al (2011) and Cullen et al (2012); β 2 < 0 in Kempf and Ruenzi (2008); and β 2 ¼ 0 in Chen and Pennacchi (2009).…”

Competition, reach for yield, and money market funds

“…Contrary to the majority of the positive theoretical literature on fund tournaments (Basak and Makarov, 2012), the above model does not assume a convex flow-performance relation. Although there is some evidence that the flow-performance relation for MMFs is convex (Christoffersen and Musto, 2002), that risk-taking channel is shut off to focus on the incentives generated by the tournament nature of fund competition alone.…”

“…Under a technical point of view, most theoretical papers on fund tournaments consider tournaments with only two players (winner and loser). Basak and Makarov (2012) solve a tournament with a continuum of funds assuming that a fund's payoff only depends on its performance relative to the population average. The methodological contribution of this paper is to develop a technique to solve tournaments with a continuum of players without resorting to such approximations.…”

Ranking, Risk-Taking and Effort: An Analysis of the ECB's Foreign Reserves Management

“…Tournaments take place not only in a given fund segment, but also within families of funds that belong to the same controlling group but offer On the theoretical side, a vast literature has modelled mutual fund tournaments and challenged the narrow-sense risk-shifting hypothesis, that losers gamble and winners index (Acker and Duck, 2006;Basak and Makarov, 2010;Basak, Pavlova and Shapiro, 2007;Chen and Pennacchi, 2009;Goriaev, Palomino and Prat, 2001;Taylor, 2003). The degree of risk tolerance affects the risk-ranking relationship and, under risk neutrality, may even cause winners to gamble (Basak and Makarov, 2010).…”