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Chasing Hot Funds: The Effects of Relative Performance on Portfolio Choice

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  • Mark Bagnoli
  • Susan G. Watts

Abstract

We study the way in which SEC restrictions on fund manager compensation affect portfolio choice when investors buy into funds whose recent performance has been good. We find that fund managers choose riskier portfolios than they would if there were no contracting restrictions and that these portfolios are riskier than the optimal risky portfolio. Further, if investors choose funds according to performance rank rather than performance relative to the average, these effects are exacerbated—fund managers choose even riskier portfolios. Thus, our analysis suggests a need to provide investors with information about risk-adjusted performance.

Suggested Citation

  • Mark Bagnoli & Susan G. Watts, 2000. "Chasing Hot Funds: The Effects of Relative Performance on Portfolio Choice," Financial Management, Financial Management Association, vol. 29(3), Fall.
    • Handle: RePEc:fma:fmanag:bagnoli00
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    Cited by:

    1. Kempf, Alexander & Ruenzi, Stefan & Thiele, Tanja, 2009. "Employment risk, compensation incentives, and managerial risk taking: Evidence from the mutual fund industry," Journal of Financial Economics, Elsevier, vol. 92(1), pages 92-108, April.
    2. Ni, Jinlan, 2009. "The effects of portfolio size on international equity home bias puzzle," International Review of Economics & Finance, Elsevier, vol. 18(3), pages 469-478, June.
    3. Igan, Deniz & Pinheiro, Marcelo, 2012. "The effects of relative performance objectives on financial markets," MPRA Paper 43452, University Library of Munich, Germany.
    4. Debapriya Jojo Paul & Julia Henker & Sian Owen, 2019. "The aggregate impacts of tournament incentives in experimental asset markets," Experimental Economics, Springer;Economic Science Association, vol. 22(2), pages 441-476, June.
    5. Barron, John M. & Ni, Jinlan, 2008. "Endogenous asymmetric information and international equity home bias: The effects of portfolio size and information costs," Journal of International Money and Finance, Elsevier, vol. 27(4), pages 617-635, June.

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