How do fund managers behave when they have recently outperformed or underperformed? Do winners hunker down and protect their gains, while losers ratchet up risk to recover. In two recent papers, Manuel Ammann and Michael Verhofen use a variety of risk measures to analyze the impact of prior performance on the risk-taking behavior of mutual fund managers. Their October 2006 paper entitled “Prior Performance and Risk-Taking of Mutual Fund Managers: A Dynamic Bayesian Network Approach” examines year-to-year changes in fund risk levels based on a large sample of U.S. mutual funds and contemporaneous risk premium data (market, size, value, momentum) over the period 1985-2003. Their subsequent November 2007 paper entitled “The Impact of Prior Performance on the Risk-Taking of Mutual Fund Managers” examines changes in fund risk levels from the first half of the year to the second half based on daily return data for a large sample of U.S. mutual funds and contemporaneous risk premium data over the period 2001-2005. In both papers, they conclude that:
- A fund manager with recent outperformance tends to elevate beta , increasing exposure to value, small-capitalization and momentum.
- A fund manager with recent underperformance tends to reduce beta. decreasing exposure to value, small-capitalization and momentum.
The authors suggest that self-preservation (staying close to benchmark) drives recent losers, while overconfidence drives recent winners. They do not relate findings to performance persistence.
In summary, recent success (failure) leads to risk-taking (risk-avoidance) among mutual fund managers.
Advisors and individual investors may want to consider whether they react in the same ways to runs of strong and weak results.
