Portfolio Rebalancing and Mutual Fund Tournament Behavior

Abstract

An implicit assumption of the tournament hypothesis of mutual fund behavior is that managers intentionally modify portfolio risk in response to interim out- or underperformance. We present empirical evidence that associations between interim performance and subsequent volatility remain present even in the absence of portfolio rebalancing. Moreover, our results suggest that such rebalancing generates changes in volatility bearing no relation to interim performance. We conclude that managers may alter holdings to control portfolio risk, but it is not predicated on prior performance. Rather, it is consistent with managers maintaining a constant style preference and time-varying volatility associated with those styles.

Keywords: mutual funds, risk shifting, tournaments

JEL Classification: G11, G23