Risk Taking by Mutual Funds as a Response to Incentives

Abstract

This paper examines a potential agency conflict between mutual fund investors and mutual fund companies. Investors would like the fund company to use its judgment to maximize risk‐adjusted fund returns. A fund company, however, in its desire to maximize its value as a concern, has an incentive to take actions that increase the inflow of investments. We use a semiparametric model to estimate the shape of the flow‐performance relationship for a sample of growth and growth and income funds observed over the 1982–92 period. The shape of the flow‐performance relationship creates incentives for fund managers to increase or decrease the riskiness of the fund that are dependent on the fund's year‐to‐date return. We examine portfolio holdings of mutual funds in September and December and show that mutual funds do alter the riskiness of their portfolios at the end of the year in a manner consistent with these incentives.