Mutual fund tournament : Risk taking incentives induced by ranking objectives ∗

Mutual funds’ performance rankings are widely publicized in the media and have a strong impact on fund flows (see, e.g., Sirri and Tufano, 1998). In this paper, we study risk taking incentives of mutual fund managers who have ranking objectives (as in a tournament). First, in a two-period model, we analyze the game played by two risk-neutral fund managers with ranking objectives. We show that in the first period, managers choose the same risk level but do not act in the interest of investors. In the second period the interim loser (i) takes more risk than the interim winner and (ii) the level of risk undertaken by the interim loser is increasing with the difference in interim performances. Second, we empirically test some predictions of the model in a sample of US diversified equity funds in 1980-1998, using a more powerful methodology than in previous studies and accounting for cross-correlation in fund returns. We find evidence that fund choice of systematic risk in the last quarter of the year is negatively related to the performance over the first three quarters of the year, which is consistent with the model.