Should We Expect Superior Managers to Be Stars? (Dis)Incentive Effects of Fund Flows in Money Management
Juan M. Sotes-Paladino
The University of Melbourne - Department of Finance
November 20, 2012
Using a dynamic portfolio choice framework, I argue that the incentives given by investors' flows can make skilled fund managers difficult to detect. When flows are a convex function of end-of-period performance relative to peers, superior managers in my model optimally adopt contrarian strategies with respect to peers until a desired outperformance margin is achieved. Thereafter, they hedge against relative underperformance by investing like the herd. Convex fund flows may then induce excessive risk-taking in certain circumstances but still result in excessive conservatism and much lower-than-attainable returns on average. More generally, small differences in the flow-performance relationship can result in substantially different average risk-taking (herd vs. contrarian) behavior and return profiles by identical managers. In addition, traditional measures fail to adjust fund performance for the type of risks skilled managers take. Using a sample of top US mutual funds I present evidence supporting the model-implied relation between funds' herd/contrarian behavior and their flow-performance relationships.
Number of Pages in PDF File: 58
Keywords: portfolio delegation, mutual funds, incomplete information, fund flows, herding, performance evaluation
JEL Classification: C61, C63, D60, D81, D82, D83, G11, G23working papers series
Date posted: August 20, 2012 ; Last revised: November 20, 2012
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