Flows, Performance, and Tournament Behavior
Creators: name: Pagani, Marco
Publisher: name: Georgia State University
Year: 2006

description: Essay 1: The Determinants of the Convexity in the Flow-Performance Relationship

There is substantial evidence that the flow-performance relationship of mutual funds is convex. In this work, I empirically investigate the determinants of such convexity. In particular, I study the impact that fund fees (marketing and non-marketing fees) and the uncertainty related to the replacement option of fund production factors (managerial ability and investment strategy) have on the convexity of the flow-performance relationship. I also analyze the impact of the priors about managerial ability and idiosyncratic risk on such convexity. The evidence suggests that marketing fees are positively related to the convexity of the flow-performance relationship. In addition, non-marketing fees do not have a negative impact on this convexity. The evidence associated with the value of the managerial and investment replacement option is mixed. Consistent with investment restrictions being relevant in explaining investors? allocation decisions, sector, index, and hedge funds exhibit lower convexity in their flow-performance relationship than respectively diversified, non-index, and mutual funds. Finally, the dispersion of the priors about managerial ability and idiosyncratic risk are positively related to the convexity in the flow-performance relationship.

Essay 2: Implicit Incentives and Tournament Behavior in the Mutual Fund Industry

The convexity of the flow-performance relationship in the mutual fund industry produces implicit incentives for mutual fund managers to modify risk-taking behavior as a function of their prior performance (Brown, Harlow, and Starks (1996)). Rather than focusing only on tournament behavior, I investigate the link between the determinants of the convexity in the flow-performance relationship and the inter-temporal risk-shifting behavior of a fund?s manager. Hence, I examine how the sources of implicit compensation incentives shape tournament behavior. The evidence indicates that the relationship between changes in managers? relative risk choices and mid-year performance is non-monotonic (U-shaped). Higher convexity in the flow-performance relationship increases the convexity of the U-shaped tournament behavior. For extreme performers, an increase in the convexity of the flow-performance relationship directly translates into higher risk-taking incentives. For average performers, the incentive to increase risk produced by the convexity in the compensation schedule is counterbalanced by an increase in the risk of termination. I find that the uncertainty about managerial ability, marketing efforts, and the size of family complexes affect the convexity of the U-shaped tournament behavior. These results are robust to the consideration of termination risks due to funds? organizational form, investment objectives, or past performance. My results suggest that the risk strategies of younger funds, funds spending more on marketing, funds belonging to smaller families, sector funds, funds that are team-managed, or funds that have experienced consistent poor performance are more sensitive to intermediate performance.