Mutual Fund Tournaments: The Sorting Bias and New Evidence

Christopher G. Schwarz University of California at Irvine

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Previous ndings regarding the risk-shifting behavior of mid-year underperforming mutual fund managers are mixed. In this article, I show that this is due to a sorting bias, which is caused by the sorting of rst-half risk levels when establishing relative midyear performance. Even without risk-shifting behavior, mean reversion of these sorted risk levels results in the detection of tournament behavior. After correcting for this bias, I nd evidence supporting the hypothesis that rst-half underperforming managers increase portfolio risk during the second half of the year and that this tournament behavior is not dependent on rst-half market conditions. (JEL G11, G23, G32)

An important question concerning nancial agents is how relative mid-period performance affects their subsequent risk preferences. In their seminal work on mutual fund tournament behavior, Brown, Harlow, and Starks (1996) (BHS) are the rst to hypothesize and document that mutual fund managers, although typically compensated with a xed fee based on assets under management, have incentives to alter their second-half-of-the-year risk levels based on their mid-year performance rankings. Specically, rst-half underperforming managers increase their risk levels in an attempt to improve their positions against other managers, while rst-half outperforming managers reduce risk levels to preserve their positions. Given that Chevalier and Ellison (1997) and Sirri and Tufano (1998) nd that a disproportionate amount of investor ow volume is directed toward the top-performing funds each year, this risk-increasing tournament behavior seems like a rational response by compensation-maximizing managers. However, empirical evidence on mutual fund tournament behavior is diverse, suggesting that the strength and direction of tournament behavior change
Part of this work was performed while the author was a visiting doctoral fellow at the Yale International Center for Finance. The author would like to acknowledge the very extensive comments of the Editor and an anonymous referee and thank Stephen Brown, John Buonaccorsi, Steve Gill, David Hirshleifer, Iuliana Ismailescu, Yawen Jiao, Philippe Jorion, Sreya Kolay, Mark Potter, Jonathan Reuter, David Smith, Zheng Sun, and Lu Zheng as well as seminar participants at the University at AlbanySUNY and conference participants at the 2008 FMA Annual Meeting, including discussant Vicentiu Covrig, and the 2009 Financial Intermediation Research Society (FIRS) Conference on Banking, Corporate Finance, and Intermediation, including discussant Dan Li. All errors are the responsibility of the author. Send correspondence to Christopher Schwarz, Assistant Professor of Finance, Paul Merage School of Business, University of California at Irvine, Irvine, CA 92697-3125; telephone: (949) 824-0936; fax (949) 824-8469. E-mail: cschwarz@uci.edu. c The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com. doi:10.1093/rfs/hhr091 Advance Access publication October 4, 2011

The Review of Financial Studies / v 25 n 3 2012

over time or that the different empirically derived measures are problematic (e.g., Chevalier and Ellison 1997; Busse 2001; Qiu 2003; Kempf, Ruenzi, and Thiele 2009; Elton, Gruber, Blake, Krasny, and Ozelge 2010). These conicting results leave the important issue unanswered: how and whether previous return performance motivates mutual fund managers to modify their risk-taking behavior.1 I hypothesize that the varying results are due to a sorting bias. Each year, the existing methodology sorts managers by their rst-half returns. Managers rst-half return standard deviations are then used as the baseline risk levels when measuring second-half-of-the-year risk shifting. However, given the dependence of risk and return, return sorting will also likely sort risk levels as well.2 For example, if the market performed well, the funds with higher rsthalf returns will also tend to have higher rst-half risk. Because of this risk sorting, even if managers do not engage in second-half risk-shifting behavior, it will appear that risk-increasing tournament behavior occurs as the mean reversion of risk levels over the second half of the year will cause the rst-half high-return funds risk levels to decline relatively more than the rst-half lowreturn funds risk levels. Alternatively, if the market performs poorly over the rst half of the year, the funds risk levels will again be sorted, but in this case funds with higher rst-half returns will tend to have lower rst-half risk. It will therefore appear that risk-decreasing tournament behavior occurs even when it does not exist due to the mean reversion of risk levels during the second half of the year. Thus, the sorting bias varies over time depending on the direction and magnitude of rst-half risk sorting. This sorting bias is distinct from measurement error biases identied by Chevalier and Ellison (1997) and Busse (2001). Chevalier and Ellison (1997) note that the use of returns over a period to estimate funds risk levels at the end of that period can cause a bias, while Busse (2001) nds that daily autocorrelation of returns can cause measurement error when estimating risk levels from monthly returns.3 The sorting bias, in contrast, stems from a fundamental relationship between return and risk present in nancial models. After recreating the conicting tournament results over seventeen years of data, I test the hypothesis in various ways. First, I discuss the theoretical basis for the sorting bias. Second, I use data on mutual funds over the 19902006 period and nd that the amount and direction of tournament behavior are highly
1 The behavior of managers in a tournament setting affects other industries as well. For example, Brown,

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Goetzmann, and Park (2001) examine tournament behavior in the hedge fund industry. Other studies examining mutual fund tournament behavior in more specialized circumstances include Kempf and Ruenzis (2008) examination of tournament behavior in mutual fund families and Paganis (2006) analysis of what manager and fund characteristics are more likely to lead to tournament behavior.
2 For example, previous studies expect or nd a relationship between risk and return. (See Markowitz 1952 and

Sharpe 1966.)
3 Chevalier and Ellison (1997) note that the measurement bias created by estimating end-of-June risk levels using

January to June returns would be correlated with excess returns. However, in unreported results, I nd that even using end-of-June portfolio holdings will lead to a strong sorting bias.

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Mutual Fund Tournaments: The Sorting Bias and New Evidence

correlated with the level of risk sorting during the rst-half return-sorting phase of the tournament methodology. Finally, I demonstrate this bias numerically by observing signicant tournament behavior results even when risk levels are assigned randomly. I also nd in the simulated data a signicant, positive correlation between the level of risk sorting during return sorting in the rst half of the year and the subsequent tournament behavior, which is similar in magnitude to the empirically observed correlation. I then introduce two methodologies to correct for this bias. New methodologies are required as the current practice of examining portfolio-level risk changes estimated from either return data or portfolio holdings results in the sorting bias. Although these new methodologies utilize portfolio holdings, they are distinct from currently utilized methodologies.4 In the rst methodology, I analyze individual position changes over the second half of the year. Examining position changes allows for an evaluation of managers risk management relative to their own holdings as well as for the ability to control for other security characteristics that may inuence trading. The second methodology examines the differences between the observed portfolio risk levels in the second half of the year and baseline risk levels based on bootstraps of nonrisk-based trading by managers. Through bootstrapping, I control for any risk changes that would occur simply due to random trading. My ndings generally support the original risk-increasing tournament behavior conclusion drawn by BHS. Rather than nding conicting results across time, I nd that any signicant overall and individual yearly results show underperforming managers increasing the risk of their portfolios in the second half of the year. I also nd that tournament behavior is not dependent on the overall markets rst-half performance. This article adds to the literature in two ways. First, I add to the literature on biases in methodological tests.5 While I directly address only tournament behavior, examining relative changes in the mutual fund industry after sorting may bias other results as well. The methodologies suggested in this article can be applied to other circumstances where it is appropriate to use portfolio holdings data. Second, I am able to reconcile the conicting results found in past empirical studies on tournament behavior by demonstrating that prior results, based on either portfolio returns or portfolio holdings, are related to risk differences between the rst-half outperforming and underperforming funds in the sorting period and not due to other factors such as shifts in manager behavior over time or changing market conditions. The rest of this article is organized as follows. Section 1 presents information on the data used in this study. Section 2 discusses the empirical results for
4 Chevalier and Ellison (1997), Kempf, Ruenzi, and Thiele (2009), and Elton et al. (2010) use portfolio holdings to

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evaluate tournament behavior. When evaluating the impact of risk shifting on mutual fund performance, Huang, Sialm, and Zhang (2011) also use portfolio holdings when calculating their risk-shifting measure.
5 For example, Brown et al. (1992) study the bias introduced into the mutual fund persistence methodology by

survivorship bias.

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tournament behavior using the existing methodology and the sorting bias. Section 3 contains results on tournament behavior using my new empirical specications. Section 4 presents the conclusion. 1. Data Data for this study come from three sources. The rst is the Center for Research in Security Prices (CRSP) Mutual Fund database, which includes fund characteristics, net asset values (NAVs), returns, and assets. I use data from January 1990 to December 2006. CRSP lists each share class of a fund as an individual entry; thus, I merge share classes of funds to yield a nal and complete dataset that consists of unique mutual funds. This work is done by a combination of automatic share class identication and manual sorting. Once all share classes of a fund are identied, weighted average performance statistics are computed using share class net assets.6 Fund categories are determined by various investment style codes. Because CRSP does not have the same style code data in all of the sample years, each year I include funds that have an equity style in the Standard & Poors Detailed Objective Code eld or any of the equity codes identied by P astor and Stambaugh (2002), excluding funds in sector or balanced styles. For a fund to be included in a particular years analysis, all monthly returns must exist. In almost all cases, once a fund exists, all monthly returns are available until the funds removal from the dataset. Thus, this limitation will affect only new funds introduced in the middle of a year or funds merging or closing in the middle of the year. I also remove index funds by removing funds that have index, indx, idx, :index, :indx, or :idx in their names. The second source of data is the Thomson Financial Mutual Funds Holding Dataset (TFDS). The TFDS contains information on the holdings of mutual funds portfolios, which are reported on either a quarterly or semiannual basis. Portfolio holdings data include shares owned, prices, and total asset information. I link the TFDS to the CRSP Stock dataset through the CUSIP information provided.7 This allows for a computation of portfolio weights using the prices as of the holdings report date. Only funds with portfolios containing at least 70% of their assets in stocks are included in my analyses. Funds are also excluded if their total assets reported in TFDS are less than $10 million. This combined dataset is then linked to the CRSP Mutual Fund dataset using the MF Links les available via Wharton Research Data Services
6

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CRSP does not have net assets for a small number of share classes, especially at the beginning of the sample period. In these cases, I compute fund statistics using a simple average of all share classes information. CUSIP eld from the TFDS database. Whereas CRSP always reports the most recent CUSIP information, the TFDS data are not updated. Once I match the two datasets using CUSIP numbers, any time-series matching makes use of PERMNO. I also correct for the share split problem if the le and report dates are not the same. For more information on the holdings data issues, please see Bolding and Ding (2004).

7 To be more accurate, I utilize the NCUSIP eld as of the ling date from the CRSP Stock database and the

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Mutual Fund Tournaments: The Sorting Bias and New Evidence

(WRDS).8 This link le focuses largely on equity funds, as does this and prior tournament analyses. For a mutual fund to be included in the holdings analysis for a particular year, the fund must report holdings as of the end of June and December. This restriction is used to ensure that the portfolio changes observed are over exactly the same tournament period as the previous literature. This particular restriction eliminates some observations, as mutual funds may report their holdings on different six-month cycles, such as May and November. The holdings data also have gaps in the reporting dates, and therefore some funds may have portfolios listed only as of June or December but not both. 2. Risk Management Measurement with Portfolio Returns 2.1 Prior methodology I begin by compiling tournament results over the 19902006 period using the CRSP mutual fund dataset and the methodology commonly used in the literature. For each year y , I compute the rst-half return (RTN) for each mutual fund i : RTNiy = (1 + JanReti y ) (1 + FebRetiy ) . . . (1 + JunRetiy ) 1. (1)

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I also compute the risk adjustment ratio (RAR), which is a ratio of the secondhalf return standard deviation over the rst-half standard deviation: 1HAVGi y )2 , 5 (2) where 1HAVG and 2HAVG are the average returns over the rst and second halves of the year, respectively. As with the previous studies, I then form a 2 2 contingency table in which funds are placed into one cell based on whether funds returns are above or below that years median RTN value and whether funds RARs are below or above that years median RAR value. If underperforming funds tend to have above-median RARs, this is evidence that underperforming managers are raising their risk levels to attempt to catch up with their peers, whereas if underperforming funds tend to have low RARs, underperforming managers are reducing their risk, perhaps because of career concerns. Results for 19902006 are compiled in Table 1. My results match the prior results in the literature. BHS (1996) report that underperforming managers increase risk in the 1976-to-1991 period my results show this behavior in both 1990 and 1991.9 Several recent papers RARi y =
8 In a very limited number of cases, two linking numbers are assigned to the same portfolio. In that case, I use the

Dec m = J ul (rimy

2HAVGiy )2 5

J un m = J an (rimy

second linking code. Assigning both portfolios to those funds does not alter the results.
9

Although data are available prior to 1990, I start the analysis in 1990 due to difculty identifying actual style descriptions.

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Table 1 Contingency table tournament results Low RTN (Losers) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Obs. 634 667 658 824 995 1109 1219 1321 1588 1707 1783 1862 1970 1966 2096 2150 2254 Low RAR 20.98 16.49 25.23 31.43 23.82 22.99 18.70 34.07 30.54 26.42 27.93 38.51 29.09 26.70 25.24 24.09 21.69 High RAR 29.02 33.58 24.77 18.57 26.23 27.05 31.34 15.97 19.46 23.61 22.10 11.49 20.91 23.30 24.76 25.91 28.31 High RTN (Winners) Low RAR 29.02 33.58 24.77 18.57 26.23 27.05 31.34 15.97 19.46 23.61 22.10 11.49 20.91 23.30 24.76 25.91 28.31 High RAR 20.98 16.34 25.23 31.43 23.72 22.90 18.62 33.99 30.54 26.36 27.87 38.51 29.09 26.70 25.24 24.09 21.69
2 p -value 0.00 0.00 0.82 0.00 0.12 0.01 0.00 0.00 0.00 0.02 0.00 0.00 0.00 0.00 0.66 0.09 0.00

16.41 78.62 0.05 54.54 2.41 7.47 78.33 172.24 78.03 5.29 24.03 543.52 52.63 9.13 0.19 2.83 39.40

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This table reports tournament behavior results using the traditional contingency table methodology each year from 1990 to 2006. Fund returns are computed for the rst six months of the year (Equation (1)), and then a fund is put into the Low RTN group if its return is below the median and into the High RTN group otherwise. RAR is formed by the ratio of the second-half standard deviation of a funds monthly returns divided by the rst-half standard deviation (Equation (2)). If a funds ratio is less than the median, it is classied as Low RAR and vice versa. A contingency table is formed on these two variables. Percentages of observations in each cell are reported as well as chi-squared and p -values for signicance tests based on a null hypothesis of independence. Signicant at the 1% level; signicant at the 5% level.

note the opposite pattern over the 1990s and 2000s. For example, Elton et al. (2010) report underperforming managers reducing their risk levels from 1998 to 2004.10 My results are consistent with those ndings. The most notable feature of this table is the large variation in tournament results from one period to the next. For example, the years 1990 and 1991 are in disagreement with later years, such as 2001. Tournament behavior from 1996 to 1997 reverses with underperforming managers adding risk in one year and removing risk in the other. Given that the direction of tournament behavior is reported to change from one year to the next, the cause of the conicting results could not be due to long-term structural changes in the industry. Moreover, it is difcult to draw unambiguous inferences from the long-term record. 2.2 Relationship between tournament behavior and sorting One potential issue with the prior methodology is risk sorting. According to portfolio models, such as Markowitz (1952) and Sharpe (1966), and theoretical

10 This result is not unique to their portfolio beta and standard deviation methodology. The same result is found

using the contingency table methodology.

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Mutual Fund Tournaments: The Sorting Bias and New Evidence

models, such as the capital asset-pricing model (CAPM),11 risk and return are not independent in diversied portfolios, such as those held by mutual funds.12 Therefore, when cross-sectional returns are sorted during one period, this sorting is also most likely concurrently sorting cross-sectional risk as well. If this is true, prior evidence on tournament behavior could be due to crosssectional mean reversion in risk levels and not the managers actions.13 For example, assume I have two mutual funds, Fund X and Fund Y. The funds managers have no skill, but attempt to outperform each other while having the same risk leveli.e., standard deviation. For simplicity, assume that both funds target the same risk level as the average mutual fund, and that ex ante risk and return are positively related, as suggested by the previously referenced asset-pricing models. Based on their positions over the rst half of the year, Fund X experiences standard deviation x 1 , while Fund Y experiences standard deviation y 1 . Inherently one fund will have a higher risk level than the other due to the managers inability to perfectly forecast securities risk and return levels or due to securities temporary departures from their own true risk levels. In addition, one fund will experience a higher return than the other. Ex ante, the fund with the higher risk level should also generally experience the higher return. However, the ex post relationship of return and risk depends on the strength of the market. If the market performs well in the rst half of the year, the fund with the higher risk level will also tend to have the higher return, and if the market performs poorly in the rst half of the year, the fund with the higher risk level will tend to have the lower return. Over the second half of the year, Funds X and Y then experience realized standard deviations x 2 and y 2 , respectively. Given that both managers target the same risk level, one would expect each funds risk level over the second half of the year to display mean reversion as errors in security risk levels would revert toward their true values and managers will change the composition of their portfolios. If the market performs well in the rst half of the year, the fund with the higher return in the rst period, which will likely have the higher risk level as well, will be more likely than the low return fund to experience a relatively lower risk level in the second half of the year compared with its rst-half risk level. The opposite will be true if the market performs poorly because the high-return fund will tend to have lower rst-half risk.

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11 See Sharpe (1964) and Lintner (1965). I refer to these models because they provide evidence that sorting returns

will also sort risk levels.

12 Funds that invest in only a limited number of funds or sectors may have larger levels of idiosyncratic risk.

However, sector funds are not included in this analysis, and highly concentrated mutual funds are rare.
13 Tournament behavior is studied by examining whether cross-sectional risk changes are related to performance.

First-half risk levels are used as a baseline level; thus, relative rather than absolute levels are considered. When discussing mean reversion in tournament tests, I am not considering stochastic changes in the market level of risk, which will inuence the aggregate risk level of all-equity mutual funds.

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The Review of Financial Studies / v 25 n 3 2012

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Figure 1 1991 First-half return/risk sorting This gure displays the relationship between rst-half return and risk for mutual funds in 1991. First-half returns, computed with Equation (1), are plotted on the y -axis, while rst-half monthly standard deviations are plotted on the x -axis.

Thus, when returns are sorted in the rst stage of the tournament test and if risk levels are mean reverting, the standard tournament tests are biased. In this two-fund environment, it is possible to show under reasonable assumptions that the standard test statistic is biased. It is also possible to demonstrate that the direction of the sorting bias changes depending on the performance of the market.14 To provide a visual demonstration of the sorting bias, consider two of the strongest tournament behavior years from Table 1: 1991 and 2001. Results from 1991 conclude that underperforming managers are increasing risk, whereas 2001s results indicate that underperforming managers are decreasing risk. In 1991, the market performed well in the rst half of the year, whereas the market performed poorly in 2001. Figures 1 and 2 plot rst-half returns against rst-half standard deviations. These two gures show the risk sorting described previously. In 1991, there is a positive and fairly linear relationship between return and risk in a year with a strong stock market. Funds in the low-return group, which were shown to increase risk in the second half of the year, almost universally have lower risk levels in the rst half of the year. The year 2001 shows the opposite result, with a negative relationship between rst-half return and risk. Again, the risk
14 Due to the length of these proofs, they have been omitted from the text, but they are available in an online

appendix.

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Mutual Fund Tournaments: The Sorting Bias and New Evidence

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Figure 2 2001 First-half return/risk sorting This gure displays the relationship between rst-half return and risk for mutual funds in 2001. First-half returns, computed with Equation (1), are plotted on the y -axis, while rst-half monthly standard deviations are plotted on the x -axis.

sorting is in the direction one would expect if mean reversion is causing the tournament behavior results. 2.3 Relationship between risk sorting and empirical results In the previous section, I discussed that if risk levels are mean reverting and sorting on return also sorts on risk, the standard tournament test methodology will suffer from a sorting bias. In this section, I examine the relationship between the level of risk sorting and the amount of tournament behavior in the CRSP data over the sample period. I compute the Frequency Difference, which is used as the measure of tournament behavior under the contingency table approach. This value is computed as the difference of the percentages of observations in the High RAR and Low RAR cells for Low RTN funds reported in Table 1. I also compute the Before Ratio, which is the ratio of high-performing funds median standard deviation divided by the underperforming funds median standard deviation in the rst half of the year. Values of this ratio greater than one indicate that the risk levels of the high-return portfolios are signicantly higher in the rst half of the year, and ratio values less than one indicate that the low-return portfolios have signicantly higher risk in the rst half of the year. In addition to the contingency tables results, I also compute tournament results using the regression and ranking approach. In this model, the differences between funds second-half standard deviations and rst-half standard deviations are regressed against funds rst-half performance rankings. Funds are ranked from zero to

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Table 2 Comparison of risk sorting and tournament behavior 16 month Std. Dev. Year Frequency Difference Rank Coefcient Low RTN High RTN 0.056 0.051 0.021 0.021 0.028 0.016 0.026 0.041 0.038 0.051 0.068 0.047 0.038 0.048 0.023 0.033 0.034 712 month Std. Dev. Low RTN 0.051 0.046 0.027 0.024 0.034 0.025 0.042 0.047 0.093 0.042 0.050 0.069 0.077 0.027 0.032 0.028 0.020 High RTN 0.058 0.054 0.024 0.023 0.030 0.027 0.049 0.049 0.095 0.053 0.073 0.062 0.069 0.033 0.041 0.028 0.022 Before Ratio 1.311 1.356 0.829 0.755 0.882 1.134 1.778 0.770 0.924 1.155 1.183 0.609 0.799 1.201 1.230 1.044 1.265 0.81 0.67

1990 8.04 0.005 0.043 1991 17.09 0.017 0.038 1992 0.46 0.004 0.025 1993 12.86 0.011 0.028 1994 2.41 0.000 0.031 1995 4.06 0.001 0.015 1996 12.63 0.006 0.014 1997 18.09 0.028 0.053 1998 11.08 0.007 0.041 1999 2.81 0.005 0.044 2000 5.83 0.003 0.058 2001 27.01 0.044 0.078 2002 8.17 0.000 0.048 2003 3.41 0.005 0.040 2004 0.48 0.004 0.019 2005 1.81 0.000 0.032 2006 6.61 0.011 0.027 Correlation of Before Ratio and Freq. Difference Correlation of Before Ratio and Rank Coefcient

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This table reports results comparing observed tournament behavior with risk sorting in the rst period. Fund returns are computed for the rst six months of the year (Equation (1)) and then a fund is put into the Low RTN group if its return is below the median and into the High RTN group otherwise. RAR is formed by the ratio of the second-half standard deviation of a funds monthly returns divided by the rst-half standard deviation (Equation (2)). If a funds ratio is less than the median, it is classied as Low RAR and vice versa. A contingency table is formed on these two variables. Frequency Difference is the difference of the percentages of observations in the High RAR and Low RAR cells for Low RTN funds reported in Table 1, while Rank Coefcient is the coefcient from a regression with changes in risk levels as dependent variables and funds performance rankings in the rst half of the year as independent variables. The median fund standard deviations are reported for the rst and second six months of the year for the Low RTN and High RTN groups. The Before Ratio is the ratio of the rst-half High RTN standard deviation divided by the rst-half Low RTN standard deviation. Rank Coefcient results are shown with the opposite sign to present the same conclusions as the Frequency Difference results. Signicant at the 1% level; signicant at the 5% level.

one, with the highest-performing fund receiving a ranking of one. I report the results of the relationship between the Before Ratio and tournament behavior in Table 2.15 Overall, the results are supportive of the risk-sorting hypothesis. The correlations between the level of rst-half risk sorting and tournament behavior, as measured by the contingency table and the rank regression coefcients, are 0.81 and 0.67, respectively, which are both signicant at the 1% level. In the years with statistically and economically signicant amounts of underperforming funds raising risk (1990, 1991, 1996), the risk levels for the underperforming funds in the rst half of the year are signicantly lower than the risk levels of the outperforming funds. The years in which underperforming funds signicantly lower their risk levels also agree with the risk-sorting
15 To make the comparison of the results easier, I multiply the rank regression coefcients by minus one so positive

values of both the contingency table and rank regression results indicate low-performing funds are increasing risk. I perform this transformation throughout the rest of the text. I also note that the number of signicant results using the rank regression methodology is similar to the number from the contingency table approach.

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Mutual Fund Tournaments: The Sorting Bias and New Evidence

hypothesis. In 1993, 1997, 1998, 2001, and 2002, the risk levels of rst-half low-performing funds are higher than the high-performing funds. Finally, lowand high-return funds risk levels display mean reversion in the second half of the year in the majority of years. 2.4 Numeric demonstration of risk-sorting problem The prior sections results document a signicant correlation between the level of risk sorting in the rst half of the year and the managers observed tournament behavior, which is consistent with the sorting bias. In this section, I demonstrate that these ndings are a result of the sorting bias using a numerical simulation similar to that of S. Brown et al. (1992). Monthly returns are generated from Rit = r f + i ( Rmt r f ) + it , (3) where the monthly risk-free rate is assumed to be 0.005 and it is distributed with mean zero and yearly standard deviation i . Betas, representing the funds January betas, are randomly assigned to the 2,200 funds. The distribution of the assigned betas is normal with a mean of 1.02 and an average subperiod standard deviation of 0.42. Funds are also assigned an annualized idiosyncratic risk level, which has a mean of 5.3% and standard deviation of 2%.16 The correlation between the randomly assigned idiosyncratic risk levels and betas is 0.39. These values match the empirically observed subperiod values in the CRSP data. Over the course of the year, funds monthly betas linearly change from the randomly assigned January betas to December betas. A funds end-of-the-year beta is computed as i 2 = i 1 + a (m f i 1 ) + i , (4)

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where is distributed normally with mean zero and standard deviation such that the second-half betas also have a standard deviation of 0.42. (The exact standard deviation of depends on the value of parameter a .) To calibrate the value of the mean reversion parameter a , I nd the median cross-sectional correlation of both funds betas and standard deviations over the rst and second halves of the year in the CRSP data during my sample period. The median correlation between the two subperiod betas is 0.67, and the median correlation of the subperiod standard deviations is 0.65. Using trial and error, I nd that an a value of 0.8 arrives at the betas correlation in my simulations, while an a value of 0.39 causes the correlation of the standard deviations to be 0.65.17 Funds are also assigned an end-of-the-year idiosyncratic risk level
16 In the unlikely event a fund is assigned a negative idiosyncratic risk, the value is set to zero. 17 Because the strength of the sorting bias depends on the amount of mean reversion, I also examine the amount

of mean reversion observed in the simulations compared with actual data in unreported results. I nd levels of mean reversion that closely match the data using a mean reversion parameter of 0.8 and amounts that are less than that observed in the data using a mean reversion parameter of 0.39.

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The Review of Financial Studies / v 25 n 3 2012

that has the same distributional assumptions and correlation with betas as the initially assigned idiosyncratic risk levels. Idiosyncratic risk levels mean revert through their relationship with the betas. As with the betas, idiosyncratic risk levels transition from the rst- to last-month level linearly over the course of the year. Using the generated monthly betas and idiosyncratic risk levels, I then use monthly S&P 500 returns to generate monthly returns for the 2,200 funds.18 Using the generated returns, I run the contingency table tournament test and compute the Before Ratio and Frequency Difference. I run 25,000 simulations for each year and report the median outcomes in Table 3. Panel A reports
Table 3 Simulated relationship between risk sorting and tournament behavior Panel A: Beta Correlation Matching (a=0.8) Low RTN (Losers) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Low RAR 31.73 17.59 26.82 24.18 27.41 25.55 24.77 21.82 21.59 22.23 30.32 31.02 27.27 24.14 27.41 28.14 24.23 High RAR 18.27 32.41 23.18 25.82 22.59 24.45 25.23 28.18 28.41 27.77 19.68 18.98 22.73 25.86 22.59 21.86 25.77 Frequency Difference
13.45 14.82 3.64 1.64 4.82 1.09 0.45 6.36 6.82 5.55 10.64 12.05 4.55 1.73 4.82 6.27 1.55

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16 month Std. Dev. Low RTN 0.063 0.034 0.027 0.022 0.040 0.014 0.016 0.034 0.027 0.032 0.066 0.082 0.053 0.036 0.040 0.031 0.023 High RTN 0.050 0.053 0.022 0.024 0.028 0.018 0.020 0.055 0.044 0.048 0.047 0.049 0.032 0.051 0.028 0.024 0.023 Before Ratio 0.79 1.55 0.79 1.10 0.69 1.30 1.29 1.65 1.62 1.49 0.71 0.60 0.62 1.43 0.69 0.76 0.99 0.86 0.67 0.49

Correlation of Before Ratio and Freq. Difference Correlation Between First- and Second-Half Betas Correlation Between First- and Second-Half Return Standard Deviations Panel B: Return Standard Deviation Correlation Matching (a=0.39) Low RTN (Losers) Year 1990 1991 1992 1993 1994 1995 1996 1997 Low RAR 29.41 21.00 26.05 24.68 26.32 27.09 26.77 23.82 High RAR 20.59 29.00 23.95 25.32 23.68 22.91 23.23 26.18 Frequency Difference
8.82 8.00 2.09 0.64 2.64 4.18 3.55 2.36

16 month Std. Dev. Low RTN 0.062 0.034 0.027 0.022 0.040 0.013 0.016 0.033 High RTN 0.051 0.053 0.022 0.024 0.027 0.018 0.020 0.056 Before Ratio 0.82 1.57 0.79 1.10 0.69 1.32 1.29 1.67 (continued)

18 These data were obtained from the Standard and Poors website.

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Mutual Fund Tournaments: The Sorting Bias and New Evidence

Table 3 Continued Panel B: Return Standard Deviation Correlation Matching (a=0.39) Low RTN (Losers) Year Low RAR High RAR Frequency Difference 16 month Std. Dev. Low RTN High RTN 0.044 0.048 0.047 0.049 0.032 0.052 0.028 0.024 0.023 Before Ratio 1.63 1.52 0.73 0.60 0.60 1.48 0.69 0.77 0.97 0.69 0.87 0.65

1998 24.32 25.68 0.027 1.36 2.55 1999 23.73 26.27 0.032 0.065 2000 28.32 21.68 6.64 2001 28.82 21.18 0.081 7.64 2002 25.50 24.50 0.053 1.00 2003 23.95 26.05 0.035 2.09 2004 26.18 23.82 0.040 2.36 2005 26.82 23.18 3.64 0.031 2006 24.77 25.23 0.024 0.45 Correlation of Before Ratio and Freq. Difference Correlation Between First- and Second-Half Betas Correlation Between First- and Second-Half Return Standard Deviations

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This table reports results from numerical simulations. Each year, 2,200 funds are assigned beginning betas randomly. End-of-the-year betas are determined via Equation (4). Funds are also assigned beginning- and endof-the-year idiosyncratic risk levels. Over the course of the year, funds betas and idiosyncratic risk levels linearly shift from the beginning values to the ending values. Using betas and idiosyncratic risk levels, monthly returns are generated using the total S&P 500 returns, and contingency table tournament results are calculated as described in Table 1. For each year, 25,000 simulations are performed and the median results are reported. Frequency Difference is the difference of the percentages of observations in the High RAR and Low RAR cells for Low RTN funds. The median fund standard deviations are reported for the rst six months of the year for the Low RTN and High RTN groups. The Before Ratio is the ratio of the rst-half High RTN standard deviation divided by the Low RTN standard deviation. I report the correlation between the Frequency Difference and the Before Ratio and also report the cross-sectional correlation between funds rst- and second-half betas and standard deviations. Panels A and B report results using an a value in Equation (4) of 0.80 and 0.39, respectively. Signicant at the 1% level; signicant at the 5% level.

results with the a parameter in Equation (4) set at 0.8 to match the observed correlation of the betas, whereas Panel B reports results using an a value of 0.39 to match the observed correlation of the standard deviations.19 Even with no tournament behavior embedded in the simulations, the timeseries properties of the simulated results closely match the prior sections empirical ndings. There is a strong, signicant correlation between the Before Ratio and tournament behavior, which is of similar magnitude to the results in Table 2. Both tables results have approximately the same number of signicant yearly results. The simulated yearly results also alternate between the risk-increasing and risk-decreasing directions. For example, 1991 and 2001 have signicant results in opposite directions, which is again similar to the empirical results in Table 2. Finally, the levels of risk sorting in the rst halves of the years are also similar. While the time-series properties of the simulation results match the empirical results, some individual years results are not consistent. In 1990, for
19 In addition to the tests reported, I also run the simulations with alternative specications as robustness checks.

For example, I use a middle ground mean reversion parameter of 0.6. I also run models where beta and idiosyncratic risk are independent. In all cases, the conclusions match those presented in Table 3.

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The Review of Financial Studies / v 25 n 3 2012

example, the simulations show winners increasing risk, while the empirical results nd winners decreasing risk. The main driver of the tournament behavior differences between the two panels is differences in the risk sorting in the rst period, which is what drives the direction of the sorting bias. For example, in 1990, the risk-sorting direction is positive in the empirical data, which leads to winners decreasing risk, whereas the simulated data has negative risk sorting and winners increasing risk.20 Conditional on the sorting differences, both of these results are consistent with the sorting bias. Thus, although the tournament behavior for some years is inconsistent, these differences do not invalidate the sorting bias. In fact, the overarching conclusion is that the simulations demonstrate that one could nd the exact same empirical timeseries tournament result properties observed in Table 2 without any tournament behavior. 3. Risk Management Measurement with Portfolio Holdings 3.1 Risk measure using active portfolio holding changes Given the relationship between risk sorting and tournament behavior, the use of a relative risk change measure could bias any tournament results. One way to overcome this bias is to use portfolio holdings to examine managers decisions. I can compare the risk characteristics of portfolio changes against the portfolios average risk levels. If managers are attempting to alter risk levels in the direction predicted by the risk-increasing tournament hypothesis, I should observe underperforming managers systematically selling low-risk securities and buying high-risk securities relative to their portfolios average. I should observe the opposite if the risk-decreasing tournament hypothesis holds. By using each portfolios holdings information to establish a riskchanging baseline, I avoid creating a bias. For each year, I calculate changes in funds stock holdings utilizing share changes in order to capture active decisions by the portfolio managers. The change measure for every security j in every portfolio i for each year y is WgtChgjiy = (DecShares jiy JuneShares jiy ) DecPrice j y , DecAssetsi y (5)

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where DecAssets is the total dollar value of December equity holdings.21 Then, using daily returns from the rst six months of the year, I calculate the standard deviation and total return of each security and nd the equally
20 There are a variety of reasons that the risk sorting in the rst period in the simulated data is different from the

actual data even though the beta model is able to explain a large portion of mutual fund returns (e.g., Carhart 1997). For example, mutual fund managers could have overweighted certain industries in some years, such as the technology sector in the late 1990s. Mutual fund managers could dynamically shift their market exposures based on market returns. Since I am simulating random trading, the simulations do not reect any of this trading.
21 This measure is the same measure Wermers, Yao, and Zhao (2007) use. I correct for any stock splits between

June and December.

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Mutual Fund Tournaments: The Sorting Bias and New Evidence

weighted average security standard deviation and security return for each fund based on its June holdings. By using security characteristics from the rst half of the year, I am examining the intended risk and return changes by managers. I next calculate the Adjusted Standard Deviation and Adjusted Return of each stock in the portfolio by taking each securitys standard deviation and return and subtracting the June portfolios average values. I regress WgtChg (scaled by 100) against that securitys Adjusted Standard Deviation and Adjusted Return. I include an interaction between both Adjusted Standard Deviation and Adjusted Return and either Low Dummy (LD*AS and LD*AR), which is one if the funds performance is below the median in the rst half of the year and zero otherwise, or Return Rank (RR*AS and RR*AR), which is the percentile ranking of the funds performance in the rst half of the year, where one represents the best-performing fund. I should nd positive, signicant loadings on the Adjusted Standard Deviation interaction terms if low-performing managers are increasing risk and vice versa if managers are decreasing risk. Finally, I include Low Dummy or Return Rank as well as net fund ows over the rst half of the year, computed as in Sirri and Tufano (1998), as net fund ows will inuence the average weight change for each fund. The nal specication is outlined in Equation (6). WgtChg jiy 100 = 0 + (r j y 1 r iy 1 )1 + ( j y 1 iy 1 )2 +LowDummyi y 3 + F H Flowi y 4 +LowDummyi y (ri y 1 r iy 1 )5 +LowDummyi y (i y 1 i y 1 )6 (6) Unlike previous studies, this study allows for the possibility of momentum trading, found by Grinblatt et al. (1995), for instance, by including the Adjusted Return variable. The inclusion of an interaction term between adjusted return and rst-half performance is due to previous researchers nding differences between how losing and winning managers react to returns.22 I use portfolio-level clustered standard errors rather than OLS standard errors because tournament behavior decisions take place at the fund level. I run each model with funds returns ranked over the whole sample of funds as well as funds returns ranked within styles. Coefcients are computed using Fama and MacBeth (1973), and standard errors are computed using Newey and West (1987) with four lags. Results are reported in Table 4. Panel A
22 For example, Jin and Scherbina (2011) nd that new mutual fund managers are more likely to sell losers than

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continuing fund managers. Shapira and Venezia (2001) nd that both individual and professional investors suffer from the disposition effect. Many researchers nd evidence of window dressing. For example, Meier and Schaumburg (2004) nd that funds with more recent poor performance are likely to window dress. However, they only utilize the prior quarters performance, whereas I use much staler performance. Lakonishok et al. (1991) nd that pension managers oversell their loser positions in the fourth quarter. Morey and ONeal (2006) also nd signicant window dressing by bond mutual fund managers. Other research on window dressing includes Musto (1997, 1999), Lee, Porter, and Weaver (1998), ONeal (2001), and Sias (2007).

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The Review of Financial Studies / v 25 n 3 2012

Table 4 Tournament behavior results measured using active trading Panel A: Overall Results Ranked Together Coeff. Adj. Ret. Adj. Std. First-Half Flow Low Dummy LD*AR LD*AS Return Rank RR*AR RR*AS Observations Adj. R -squared 0.036 1.217 0.099 0.046 0.097 0.677
t -value

Ranked by Style
t -value

Coeff. 0.118 2.526 0.093

Coeff. 0.040 1.025 0.096 0.063 0.106 1.314

t -value

Coeff. 0.134 2.821 0.091

t -value

3.69 7.74 7.28 2.46* 8.65 1.64

4.07 3.84 6.67

0.124 0.202 1.763 6.96M 0.42% 6.96M 0.49%

4.15 5.42 2.16

3.62 5.44 7.22 5.13 8.48 2.33

4.53 3.09 6.62

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0.143 0.235 2.226 6.96M 0.52%

5.22 7.27 1.73

6.96M 0.44%

Panel B: Low Dummy Interaction Results by Year Ranked Together Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Value 0.684 3.894 1.443 2.034 1.391 0.060 1.066 4.119 1.547 0.791 0.862 0.262 0.879 1.182 0.066 3.056 1.115
p -value

Ranked by Style Value 1.485 5.245 2.056 2.940 5.972 0.081 0.512 3.492 1.709 0.191 0.829 0.463 0.936 2.475 0.435 2.577 2.920
p -value

0.61 0.09 0.20 0.27 0.35 0.94 0.45 0.31 0.29 0.39 0.05 0.60 0.24 0.10 0.95 0.01 0.31

0.34 0.01 0.10 0.17 0.02* 0.91 0.68 0.44 0.25 0.84 0.05* 0.35 0.21 0.00 0.63 0.03* 0.00

This table reports tournament behavior results using active portfolio changes from 1990 to 2006, as specied in Equation (6). The dependent variables are share changes, dened as the dollar value difference between December and June shareholdings indexed by the total value of the equity holdings in December (Equation (5)). Adj. Ret and Adj. Std. are the securitys portfolio excess rst-half return and standard deviation. First-Half Flow is the funds net ow, dened as in Sirri and Tufano (1998). Low Dummy is one if the funds performance is below the median in the rst half of the year and zero otherwise. Return Rank is the percentile ranking of the funds performance in the rst half of the year, where one represents the best-performing fund. Return Rank results are presented with the opposite sign to present the same conclusions as the Low Dummy results. LD*AR and LD*AS are interaction terms between Low Dummy and Adj. Ret. and Adj. Std., respectively. RR*AR and RR*AS are interaction terms between Return Rank and Adj. Ret. and Adj. Std., respectively. The rst two models report results with all funds considered in aggregate for rst-half performance rankings, whereas the second two models report results with rst-half performance rankings determined within their style classications. Panel A presents overall results, where coefcients are computed using Fama and MacBeth (1973) and standard errors are computed using Newey-West (1987) with four lags. Panel B presents yearly values for LD AS, where standard errors are clustered by fund. Signicant at the 1% level; signicant at the 5% level.

reports overall coefcients for my models. Panel B reports yearly coefcients on the interaction between Low Dummy and Adjusted Standard Deviation as overall coefcients can mask the year-to-year changes in tournament behavior, as found previously.

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Mutual Fund Tournaments: The Sorting Bias and New Evidence

After controlling for return trading, the results indicate some evidence of risk-increasing tournament behavior in the mutual fund industry over my sample period. Two of the four models show underperforming managers increasing risk, while the other two specications nd similar but insignicant results. The yearly results reported in Panel B are largely insignicant, although any signicant results are also in the risk-increasing tournament behavior direction, as originally hypothesized. Overall, these results are substantially different from the results currently reported in the literature. An important question, however, is whether this technique demonstrates the sorting bias. The correlation between the Before Ratio from Table 2 and the four yearly coefcients time-series ranges from 0.07 to 0.23 and are all highly insignicant at even the 10% level.23 Chevalier and Ellison (1997) nd that the incentives for strategic risk shifting are not monotonic with respect to rst-half performance. In unreported results, I test for this possibility by modifying my specication in Equation (6). Instead of imposing a linear restriction on Return Rank, I use a piecewise regression approach on rst-half performance similar to that of Sirri and Tufano (1998). Models are run with two different specications for the piecewise variables. The rst uses three piecewise variables with cutoffs of [0,0.25), [0.25,0.75), and [0.75,1], while the second model uses four piecewise variables with cutoffs of [0,0.25), [0.25,0.5), [0.5, 0.75), and [0.75,1]. Under both specications, the additional noise from the increased number of variables as well as fewer observations to estimate each coefcient did not produce any signicant results, although point estimates suggest higher risk taking for lower performing funds, as reported in Table 4. 3.2 Tournament results with an aggregate risk measure The share change methodology relies on individual securities return standard deviations to measure managers risk-shifting actions. The overall risk level of a portfolio, however, also depends on covariance terms. Covariance terms in large portfolios can have signicant impacts, potentially making security standard deviations poor proxies for portfolio risk-level changes. Unfortunately, examination of tournament behavior using overall portfolio risk-level changes is confounded by the sorting bias. While prior work uses portfolio holdings to generate portfolio risk levels to evaluate tournament behavior (e.g., Chevalier and Ellison 1997; Kempf, Ruenzi, and Thiele 2009), all prior methods use the actual portfolios to measure baseline risk levels and changes. This can result in
23 In addition to the results presented here, I also run a number of robustness checks. First, I calculate overall

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standard errors using one to three lags rather than four. Those results are similar to the results reported. Second, I calculate yearly standard errors by clustering on security rather than portfolio. More yearly results are signicant at the 5% and 1% levels using these errors; however, all signicant results are still in the direction of the riskincreasing tournament hypothesis. Finally, I rerun the model including additional controls, stock price, volume, and market capitalization. Falkenstein (1996) nds that managers trade on these characteristics. When including these additional controls, I nd similar results, although one of the 5%-level-signicance results is signicant only at the 10% level.

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the sorting bias because, while these methods control for the mean reversion of portfolio risk due to changes in securities risk levels, they do not account for mean reversion due to non-risk-motivated trading by managers.24 In this section, I use the following bootstrap procedure that simulates non-risk-based manager trading to produce second-half baseline risk levels. Because these baseline risk levels control for mean reversion due to security risk-level changes and manager trading that is random with respect to risk, they can be used to evaluate tournament behavior. Using each funds June and December holdings, I capture the number of stocks removed, the share changes for stocks in both portfolios, and the number and dollar amount of stocks added over the second half of the year. These portfolio changes are then randomized. Every June holding is assigned a number, which is the summation of a randomly assigned number between zero and one and one-fth of that securitys intra-portfolio rst-half return ranking, where one represents the best-performing stock. The latter term is included to control for the empirically observed amount of momentum trading.25 Starting with the lowest-numbered stock, I remove the same number of stocks as observed in the actual data. Next, the observed share changes are applied to the remaining June stocks such that the lowest-remaining numbered stock receives the lowest share change (i.e., largest reduction in shares), the second-lowest-numbered stock receives the second-lowest share change, and so forth. To simulate portfolio additions, a list of stocks held by the same fund over the prior three years with year-end stock prices of more than ve dollars is generated and these stocks are also assigned numbers.26 Each stocks assigned number is the sum of a randomly assigned number between zero and one and, to again match the empirically observed amount of momentum trading, one-twentieth of each securitys rst-half return ranking.27 Starting with the highest-numbered stock, the same number of stocks as added to the actual
24 I employed a variety of techniques currently used in the literature in an attempt to create a sorting biasfree test

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without accounting for this trading. However, all of these techniques resulted in a signicant sorting bias.
25 In my CRSP sample, the median removed securitys rst-half performance percentile rank is 43. The one-

fth parameter value causes the bootstrap to also remove securities that have a median forty-third rst-half performance percentile ranking. A variety of other momentum parameter values have been attempted for robustness, and all lead to results consistent with those presented. I control for momentum trading found previously in the literature (e.g., Grinblatt et al. 1995; Daniel et al. 1997) due to a possible relationship between security return and risk levels.
26 Any fund whose security list contains fewer stocks than must be added is eliminated from the analysis. Shumway,

Szeer, and Yuan (2009) use prior portfolio holdings to evaluate managers current portfolios. Because fund managers likely have a subset of securities they evaluate for inclusion in their fund, they are unlikely to evaluate all securities in the market. Although using past holdings may omit some securities that managers consider, the overall risk prole of these securities will have the highest correlation with managers actual choices and therefore will generate the most accurate baseline risk measures. As a robustness check, I run simulations using the entire CRSP dataset as the potential addition list in unreported results. The overall tournament coefcient is positive and signicant, as reported in the text.
27 With this parameter value, both the bootstrapped and actual datas added securities have a median fty-third

rst-half performance percentile ranking. As with the momentum parameter used previously, I test a number of alternative parameter values and nd similar results.

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Mutual Fund Tournaments: The Sorting Bias and New Evidence

portfolio is selected, where the highest-numbered stock receives the largest dollar investment, the second-highest-numbered stock receives the secondhighest dollar investment, and so forth. Finally, the simulated portfolios return standard deviation is computed using portfolio returns calculated with daily second-half security returns, assuming an all-equity portfolio. This simulation is repeated 1,000 times for each fund each year, and the average bootstrapped standard deviation is used as the baseline expected risk level, assuming no tournament behavior. The excess risk level, measured as the difference between the actual December holdings second-half-of-the-year standard deviation, also assuming an all-equity portfolio, and the averaged bootstrapped standard deviation is used as the dependent variable in a regression with Low Dummy as the independent variable each year.28 Positive coefcients suggest that the low-performing rst-half managers are engaging in risk-increasing tournament behavior because their excess portfolio risk levels are relatively higher compared with those of the rst-half high-performing managers. Overall coefcients are again computed using Fama and MacBeth (1973), and standard errors are computed using Newey and West (1987) with four lags. Results are reported in Table 5. Results from this analysis support the ndings in the prior section. Over the entire seventeen-year period, the rst-half low-performing funds display relatively higher second-half risk levels compared with the high-performing funds. Although many of the yearly results are insignicant, any signicant results again support risk-increasing tournament behavior. Also, the correlations of the tournament behavior results and the Before Ratio range from 0.09 to 0.11, which indicates that these results do not suffer from the sorting bias. The results do, however, rely on the complex process of modeling random manager trading. While the bootstrap procedures assumptions are based on prior research and empirically measured values, and a number of robustness tests have been performed, the results should be viewed with some caution given this modeling complexity. With that said, the results obtained from this analysis indicate that the lack of covariance terms is not the cause of the ndings in the prior section. 3.3 Relationship between market conditions and tournament behavior An important question is whether overall market conditions impact the direction and amount of tournament behavior. While the prospects of increasing their compensation may be important, managers also have career concerns that could cause risk shifting. Kempf, Ruenzi, and Thiele (2009) examine this issue and nd that low-performing managers decrease risk if rst-half market conditions are poor, which are periods consistent with job insecurity,

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28 This difference is scaled to monthly standard deviation in percent. I also run the analysis using Return Rank and

nd similar results.

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Table 5 Tournament behavior based on portfolio risk changes Ranked Together Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Average Value 0.087 0.028 0.091 0.203 0.065 0.010 0.046 0.108 0.297 0.131 0.165 0.109 0.096 0.138 0.031 0.033 0.113 0.055
p -value

Ranked by Style Value 0.081 0.082 0.123 0.217 0.126 0.059 0.024 0.013 0.314 0.278 0.054 0.119 0.064 0.054 0.034 0.023 0.141 0.060
p -value

0.24 0.66 0.11 0.07 0.21 0.93 0.41 0.14 0.00 0.20 0.14 0.12 0.13 0.00 0.41 0.35 0.00 0.00

0.26 0.20 0.03* 0.05 0.02 0.60 0.67 0.86 0.00 0.01 0.62 0.09 0.30 0.19 0.36 0.52 0.00 0.02

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This table examines tournament behavior based on overall portfolio risk changes. Each year I calculate a funds second-half standard deviation based on the disclosed December holdings and security returns over the July-toDecember period. I then compute an expected standard deviation using a bootstrap procedure that assumes no risk-motivated trading. This procedure captures the actual number of position changes over the second half of the year for each fund and then randomizes them, assuming no tournament behavior, to create new December holdings. I calculate the second-half standard deviation based on these randomized holdings and security returns over the July-to-December period. I run the procedure 1,000 times for each fund, each year. The average value is used as the expected standard deviation if no tournament behavior takes place. Finally, each year the differences between the observed and expected values are regressed on Low Dummy, which is one if the funds performance is below the median in the rst half of the year and zero otherwise. Yearly results are reported ranking rsthalf performance over the whole sample of funds and ranking funds within their styles. Overall averages are computed using Fama and MacBeth (1973), and standard errors are computed using Newey-West (1987) with four lags. Signicant at the 1% level; signicant at the 5% level.

and increase risk during strong market conditions in which compensation concerns are likely to be most important.29 However, as noted previously, the direction of the sorting bias is likely dependent on the rst-half overall market performance. Specically, the sorting bias tends to cause low-performing funds to decrease (increase) risk in the second half of the year when the market performs poorly (well) in the rst half of the year. The previously documented relationship between market conditions and the amount and direction of tournament behavior may therefore be spurious. Using the new models of risk management that do not suffer from the sorting bias, I reinvestigate whether market conditions impact tournament behavior. For each year, I compute the rst-half overall median return of CRSP mutual funds in my sample, which proxies as the overall market health.30 I then
29 Olivier and Tay (2008) study a similar dynamic, except that they use changes in GDP instead of market returns. 30 I use the median mutual fund return instead of a market index return as these returns proxy for what mutual

funds investors are experiencing. The return values for 19902006 are 2.76, 14.84, 2.67, 4.54, 4.91, 16.68, 9.77, 14.27, 11.21, 10.51, 2.64, 5.61, 11.68, 12.16, 3.59, 0.14, and 3.24.

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Mutual Fund Tournaments: The Sorting Bias and New Evidence

Table 6 Tournament behavior and market conditions

with Return

Market Mean 0.832 1.055 2.026 0.003 0.018 2.900 3.460 0.026 0.042

+ Market Mean 1.172 0.519 1.107 0.079 0.078 1.289 1.712 0.181 0.177

+/ p-value 0.01 0.55 0.48 0.16 0.36

Before Ratio Low Return Dummy Share Change Share Change (Style) Portfolio Portfolio (Style) Return Rank Share Change Share Change (Style) Portfolio Portfolio (Style)

0.45 0.04 0.09 0.26 0.25 0.03 0.08 0.25 0.27

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0.43 0.51 0.13 0.23

This table reports results comparing tournament behavior to market conditions. The Before Ratio is the ratio of the rst-half median High RTN group standard deviation divided by the rst-half median Low RTN group standard deviation. Share Change and Share Change (Style) are tournament results using the share change methodology, while Portfolio and Portfolio (Style) are tournament results using the portfolio methodology. Tournament results where rst-half fund performance rankings are determined within each style category are labeled Style. Results for both Low Dummy and Return Rank are reported. with Return is the correlation between yearly coefcients of that variable and the median rst-half mutual fund return. Market Mean and + Market Mean are the mean values for years where the median rst-half mutual fund return is negative and positive, respectively. +/ p-value is the p -value from a t -test comparing the coefcient values in positive and negative years. Signicant at the 1% level; signicant at the 5% level.

calculate the correlation between the median rst-half mutual fund return and subsequent tournament behavior as measured in Tables 4 and 5. I also compute the mean tournament behavior coefcients for years with negative rst-half returns and positive rst-half returns and test their difference using a t -test. Finally, the relationship between the Before Ratio from Table 2 and the median rst-half return is examined because a relationship between the level of risk sorting and the median rst-half return is expected. Results are reported in Table 6. Using my new models results, I nd no signicant relationship between market conditions and tournament behavior of mutual fund managers. The difference between my new results and those found previously could be explained if there is a signicant relationship between the level of risk sorting and the market return as hypothesized. Indeed, I also nd that the Before Ratio is related to market returns. While the correlation coefcient is an insignicant 0.44 ( p -value of 0.07), underperforming funds have lower rst-half risk levels when the market performs well and higher rsthalf risk levels when the market performs poorly in the rst half of the year.31

31

The Before Ratios calculated using the simulations reported in Table 3 have positive, signicant correlations with the rst-half median returns.

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4. Conclusions This article reexamines the risk-taking preferences of underperforming rsthalf mutual fund managers in yearly tournaments. To date, the empirically documented direction and strength of tournament behavior by mutual fund managers has varied over time. Some evidence has shown underperforming managers increasing risk in the second half of the year, while other evidence has shown either no response or even underperforming managers decreasing second-half risk. While other researchers have examined what fund company and manager properties are more likely to result in signicantly stronger tournament behavior, little work has been performed trying to determine why managers seemingly change their behavior signicantly from one period to the next. In addition, almost all studies rely on return data to infer behavior of managers rather than portfolio holdings data, which have become widely available to researchers. I show through various methods that the previously found time-series variation in tournament behavior results is related to the level of concurrent risk sorting that occurs during return sorting in the rst half of the year. I then nd, using new methodologies, signicantly different results compared with the previous literature. Specically, my results support the conclusion of underperforming managers signicantly increasing risk in the second halves of years over the 1990-to-2006 timeframe. The yearly coefcients obtained are uncorrelated with the level of rst-half risk sorting and therefore do not suffer from the newly found bias. Tournament behavior is also unrelated to the overall median rst-half fund return, indicating that market returns do not cause shifts in manager behavior. Overall, my results are consistent with risk-increasing tournament behavior of mid-period underperforming nancial agents.
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