Mutual fund risk: Mean reversion or gaming?

The issue of whether mutual fund managers behave as though they are competing in a tournament has been the focus of several recent studies. Tournament behavior may be influenced by managers’ interim relative performance and whether they adjust their fund’s risk by their trades to win the tournament, improve their ranking, or prevent deterioration in their present ranking. It is an empirical issue as to whether a change in intertemporal risk is intentional or simply arises from risk mean reversion. Our methodology differentiates funds that actively trade to change risk from those whose risk is changed by trades with alternative motivations. Funds that are statistically identified as trading to change return variance or tracking error variance do not exhibit risk mean reversion. Rather, funds more commonly trade to reduce tracking error variance, particularly those with already low tracking error variances. We find weak evidence that underperforming funds intentionally trade to reduce return variance, and that trades designed to change tracking error variance are not associated with prior performance