Performance-driven risk taking in Finnish equity mutual funds

PURPOSE OF THE STUDY The purpose of this study is to assess whether mutual funds’ risk taking is driven by past performance. Emerging from the risk taking incentives caused by the asymmetric relationship between fund’s return and new flows of capital into the fund, this risk taking behavior reveals information on possible agency problems between investors and fund managers. Two different measures of risk, excess volatility over benchmark and tracking error, are employed to identify the different ways the manager can tilt the risk level of the fund. The study also distinguishes between the varying incentives between bull and bear years, thus providing more information on the behavior of mutual fund managers. By employing several fund-specific characteristics, such as mutual fund size and age, this thesis studies the ways in which these characteristic affect performance-driven risk taking. Additionally, differences in behavior between funds managed by banks and non-banks are examined, as these can partially be seen as two different markets in Finland. DATA The data set of the study consists of all actively managed Finnish equity mutual funds between 2002 and 2009. The data cover also discontinued funds, thus mainly avoiding the problem of survivorship bias. The data are in daily frequency and hold additional information on several fund-specific characteristics. Furthermore, data on several benchmark indices for different equity markets are used. RESULTS Mutual funds’ risk taking is positively related to their prior performance in bull years. This effect is not tied to calendar years. In bear years, no relationship between performance and subsequent risk taking is found. Several fund-specific characteristics affect the way the behavior appears among mutual funds. Using different measures of risk uncovers different ways of risk taking