Fund performance and subsequent risk: a study of mutual fund tournaments using holdings-based measures

Abstract

The tournament hypothesis of Brown et al. (J Finance 51(1):85–110, 1996) posits that managers of poorly performing funds actively increase portfolio risk in the second half of the year. At the same time, it is a well-established fact that stock returns and the subsequent return standard deviation are negatively related. We propose a decomposition of fund return standard deviation for the second half of the year using holdings-based measures to distinguish between risk changes that result from holding the portfolio and those that are due to managers’ trades. We extend the return gap of Kacperczyk et al. (Rev Financ Stud 21(6):2379–2416, 2008) to the return standard deviation dimension and define the volatility gap as the difference between fund return volatility and buy-and-hold portfolio volatility. Our empirical findings show that changes in the return volatilities of equity mutual funds are largely explained by shifts in buy-and-hold portfolio volatility. Thus, we find only weak evidence of tournament behavior among mutual funds.

Appendix

The table below repeats the pooled regression for non-index funds shown in Table 1 using for each fund $i$ the return rank within its respective investment style for any given calendar year $t$, $R_{[ {1,6} ],i,t}^{\mathrm{IS}}$. Specifically, we estimate the following specification: $\sigma _{[ {7,12} ],i,t} -\sigma _{[ {1,6} ],i,t} =\alpha +\beta _1 R_{[ {1,6} ]i,t}^{\mathrm{IS}} +\beta _2 \sigma _{[ {1,6} ],i,t} +\varepsilon _{i,t}$. We use the investment style definitions of Pastor and Stambaugh (2002) to sort funds into six categories: small company growth, other aggressive growth, growth, income, and growth and income, and maximal capital gains (we exclude sector funds from our sample). As before, return ranks within each investment style are normalized and expressed as fractional ranks ranging from 0 to 1.