A note on sorting bias correction in regression-based mutual fund tournament tests
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The tournament hypothesis of Brown et al. (J Financ 51(1):85–110, 1996) conjectures that mutual funds with a below-average performance over the first half of the year tend to increase their risk in the second half of the year. Schwarz (Rev Financ Stud 25(3):913–936, 2012) argues that the methodologies that are used to test this hypothesis are flawed because they are affected by a bias that results from sorting on return, which likely also sorts on risk. He argues that both the contingency and regression approaches used in the literature are affected by this sorting bias. We demonstrate that simply including the return standard deviation over the first half of the year in regression-based tests corrects for most of the bias and is just as suitable a way to control for the sorting bias as the more complex Schwarz (Rev Financ Stud 25(3):913–936, 2012) correction.
KeywordsMutual funds Tournament Sorting bias Risk shifting
JEL ClassificationG11 G12 G14
We owe special thanks to the editor Prof. Dr. Markus Schmid and an anonymous referee for very helpful comments and guidance.