Risk Shifting and Mutual Fund Performance

TLDR

Mutual funds change their risk levels significantly over time, possibly due to ill‑motivated trades by unskilled or agency‑prone managers or to skilled managers exploiting selection and timing advantages. This paper investigates the performance consequences of risk shifting and explores its economic motivations. We use a holdings‑based measure of risk shifting to track fund risk changes over time. Funds that increase risk perform worse than those that keep stable risk levels, suggesting that risk shifting signals inferior ability or agency motives.

Abstract

Mutual funds change their risk levels significantly over time. Risk shifting might be caused by ill-motivated trades of unskilled or agency-prone fund managers who trade to increase their personal compensation. Alternatively, risk shifting might occur when skilled fund managers trade to take advantage of their stock selection and timing abilities. This paper investigates the performance consequences of risk shifting and sheds light on the mechanisms and the economic motivations behind the risk shifting behavior. Using a holdings-based measure of risk shifting, we find that funds that increase risk perform worse than funds that keep stable risk levels over time, suggesting that risk shifting is either an indication of inferior ability or is motivated by agency issues.