Risk Shifting & Mutual Fund Performance: Examining the Performance Implications of Risk Shifting in Mutual Funds

Abstract

Mutual funds change theirrisk levels significantly over time. Risk shifting might be caused byill-motivated trades of unskilled or agency-prone fund managers who trade toincrease their personal compensation. Alternatively, risk shifting might occurwhen skilled fund managers trade to take advantage of their stock selection andtiming abilities. This paper investigates the performance consequences of riskshifting and sheds light on the mechanisms and the economic motivations behindthe risk shifting behavior. Using a holdings-based measure of risk shifting, wefind that funds that increase risk perform worse than funds that keep stablerisk levels over time, suggesting that risk shifting is either an indication ofinferior ability or is motivated by agency issues.