Chasing Hot Funds: The Effects of Relative Performance on Portfolio Choice

Mark Bagnoli and Susan G. Watts

Financial Management, 2000, vol. 29, issue 3

Abstract: We study the way in which SEC restrictions on fund manager compensation affect portfolio choice when investors buy into funds whose recent performance has been good. We find that fund managers choose riskier portfolios than they would if there were no contracting restrictions and that these portfolios are riskier than the optimal risky portfolio. Further, if investors choose funds according to performance rank rather than performance relative to the average, these effects are exacerbated—fund managers choose even riskier portfolios. Thus, our analysis suggests a need to provide investors with information about risk-adjusted performance.

Date: 2000
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