NCPA - National Center for Policy Analysis


May 24, 2007

Incentives influence mutual fund managers' behavior, say economists Glenn Ellison of the Massachusetts Institute of Technology and Judith Chevalier of Yale.

In "Risk Taking by Mutual Funds as a Response to Incentives," for example, the researchers show that investors pour money into mutual funds in a highly skewed way:

  • They chase winners, despite the evidence indicating that mutual funds that win in one year do not necessarily perform better in subsequent years. 
  • Funds with the highest annual returns get a huge inflow of money compared with funds that did almost as well but were not at the very top.

And since the amount of money a mutual fund makes depends on fees, not on the actual performance of the stocks they own, this gives the fund managers in the last quarter of the year some rather perverse incentives to take risks with the current investors' money to try to influence the reported end-of-year return:

  • In a fund doing well but not stellar in the first three quarters of the year, the manager has a clear incentive to take big risks.
  • If the risks pan out, the payoff in the last quarter can raise the fund's return enough to get it into a top 10 list, say, and attract a huge number of new investors.
  • If the risk doesn't pay off, the return will be lower but the fees won't be too much lower than they were before.

The study showed that managers responded rather directly to these incentives.  The managers heading toward the top of the ranking increased their risk-taking significantly in the last quarter of the year whereas those in the middle played it extra safe.

Source: Austan Goolsbee, "'The Apprentice: Omaha Edition,' Starring Warren Buffett," New York Times, May 24, 2007; based upon: Glenn Ellison and Judith Chevalier, "Risk Taking by Mutual Funds as a Response to Incentives," Journal of Political Economy, Vol. 105, No. 6, December 1977.

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