Risk Shifting and Mutual Fund Performance∗

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. ∗We thank Nick Bollen, Keith Brown, Jie Cao, Joe Chen, Jonathan Cohn, Ken French, W. Van Harlow, Marcin Kacperczyk, Christopher Polk, Stefan Ruenzi, Pablo Ruiz-Verdu, Richard Stanton, Sheridan Titman, Laura Starks, Yu Yuan, and seminar participants at the BI Norwegian School of Management, the Copenhagen Business School, Georgia State University, the University of Technology at Sydney, the University of Texas at Austin, the 2009 China International Conference in Finance, the 2009 Paul Woolley Centre Annual Conference at the London School of Economics, and the 2009 Western Finance Association Meetings for helpful comments and discussions. All authors are at the McCombs School of Business, University of Texas at Austin, Austin, TX 78712. Emails: [email protected], [email protected], and [email protected].