Wealth Conditions and Feasibility of Equivalence Between Funds Managers' and Investors' Risk Tolerances

Abstract

Whereas risk tolerance is an important parameter of financial intermediation in markets for mutual funds, formal theoretical predictions show funds managers' choices of portfolio risk tolerances can be induced in entirety by wealth considerations. An important implication of this finding is the prediction that funds' incentives for adoption of a generalist focus vary intertemporally (increase) with funds managers' equilibrium minimum wealth conditions. Within markets characterized as `Attrition Markets', resulting generalist funds are more likely to be value funds. Within markets characterized as `Indifference Markets', resulting generalist funds equally are likely to be either of value or growth funds. Formal theoretical predictions show choices of funds on basis of funds' risk tolerance alone engender transfers of wealth from investors to funds managers. These theoretically predicted transfers of wealth rationalize evidence for presence of systemic inefficiencies within markets for mutual funds. Choices of funds on basis of ability are shown to mitigate wealth transfers from investors to funds managers. Study findings provide a formal theoretical rationale for theoretical or empirical searches in quest of robust proxies for funds managers' intrinsic ability. In aggregate, formal predictions provide evidence that markets for mutual funds are indifference markets that subsume attrition markets within each specific cadre of risk tolerance.

Keywords: Mutual Funds, Risk Tolerance, Wealth, Ability, Diversification, Generalist

JEL Classification: G11, G24