Strategic Mutual Fund Tournaments

• Main Authors: Joseph Chen, Eric Hughson, Neal Stoughton, U C Davis, Claremont Mckenna
• Other Authors: The Pennsylvania State University CiteSeerX Archives
• Format: Text
• Language: English
• Subjects: Iceland
• Online Access: http://citeseerx.ist.psu.edu/viewdoc/summary?doi=10.1.1.1080.765; http://www.efa2012.org/papers/s1h1.pdf

ABSTRACT This paper characterizes the optimal strategies of mutual fund managers competing in a multi-period winner-take-all tournament. Taking account of both multiple periods and competition between more than two managers, the optimal strategies are contingent on the state at the interim date. In the final period all managers maximize the amount of risk that they add to their portfolios with the exception of the leading fund. This fund locks in its advantage by reducing risk only if it has a sufficiently large lead. Empirically, we find that consistent with the theory, funds with larger leads decrease risk; however trailing funds do not increase risks. These results are robust to using different ways of controlling for systematic risk exposures. This paper has benefitted from the comments of Richard Smith, and has been presented in seminars at Arizona State University, Claremont McKenna College, the Cologne Financial Markets Symposium, HKUST, Melbourne Business School, Nanyang Technological University, the National University Singapore, the University of Iceland, the University of Oregon and UNSW. We appreciate the seminar audiences for their comments. We are responsible for all errors. 1 Introduction An economic tournament is said to exist whenever there is a contest between economic agents and the outcome results in a clear `winner', whose prize is greater than that of the `losers.' In finance, tournaments are most often associated with mutual funds. This is because of the well-documented fund flows effect in which investors flock to the fund with the highest relative performance within a calendar year. For example, the relationship between past returns and inflows at the end of the year is demonstrated to be convex Morningstar have devised a system referred to as the `star' system. There are substantial fund flows into those mutual funds that are classified in the highest (five star) category. An important strand of empirical research on mutual fund tournaments has investigated the proposition that because ...