Academic journal article Financial Management

Chasing Hot Funds: The Effects of Relative Performance on Portfolio Choice

Academic journal article Financial Management

Chasing Hot Funds: The Effects of Relative Performance on Portfolio Choice

Article excerpt

Susan G. Watts [*]

We study the way in which SEC restrictions on fund manager compensation affect portfolio choice when investors buy into funds whose recent performance has been good. We find that fund managers choose riskier portfolios than they would if there were no contracting restrictions and that these portfolios are riskier than the optimal risky portfolio. Further, if investors choose funds according to performance rank rather than performance relative to the average, these effects are exacerbated--fund managers choose even riskier portfolios. Thus, our analysis suggests a need to provide investors with information about risk-adjusted performance.

There is no doubt that investors chase past performance.--Martin J. Gruber, 1996 AFA Presidential Address

Over the past decade, there has been a dramatic increase in public information about the relative performance of fund managers. There is also anecdotal evidence to suggest that investors use relative performance information when they select mutual funds: Higher relative performers attract more investor dollars. Shell (1998) writes, "Five-star funds. Four-star funds. Those seem to be the only mutual funds people want to buy...In essence, what star-struck investors are really doing is chasing performance."

In and of itself, such behavior by investors is not harmful, because in principle, any adverse effects can be offset by designing appropriate compensation contracts for fund managers. [1] However, the Securities and Exchange Commission (SEC) regulates the form of fund manager compensation. In particular, current SEC regulations allow fund manager compensation to include a percentage of the value of managed assets or a symmetric bonus that can depend on the fund's performance relative to the return on some market index. (See the Investment Company Amendments Act of 1970, amended section 205, or the discussion in Starks, 1987).

In this paper, we develop a model that provides insights into the interaction between SEC regulations on fund manager compensation and the recent tendency of investors to chase hot funds. In our model, we restrict fund manager compensation to meet SEC regulations and we compare three different cases. The first is a benchmark case in which investors do not chase hot funds. The second is a competitive case in which investors chase hot funds by allocating their savings to funds whose performance is high relative to average fund performance. The third is a hypercompetitive case in which investors chase hot funds by allocating their savings to funds whose relative performance rankings are highest.

When we compare the competitive case to the benchmark case, we find that in the competitive case, SEC-compliant compensation induces fund managers to choose riskier portfolios. This implies that investors are made worse off, because the risky portfolio they invest in (by using a fund manager) is riskier than the optimal risky portfolio. When we compare the hypercompetitive case to the competitive case, we find that in the hypercompetitive case, SEC-compliant

compensation induces fund managers to choose even riskier portfolios. That is, an increased provision of, and reliance on, performance ranking by investors exacerbates the problem of fund managers choosing riskier portfolios. Exhibit I illustrates these results.

Our analysis suggests that one potential solution to the investors' problem is to provide them with measures of risk-adjusted, rather than raw, performance. [2] This would require that investors be provided with more information than is envisioned by current SEC initiatives.

The paper is organized as follows. In Section I, we present our model and our results. We discuss implications and conclusions in Section II.

I. The Model

In our model, investors employ fund managers to invest their savings, because fund managers can obtain an information advantage (relative to the investors) in choosing investments at relatively low cost. …

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