Abstract: This paper examines the role of compensation
contracts in determining risk taking decisions by money managers in
the financial industry. A methodology is developed for empirically
testing and assessing the magnitude of the effect that incentive
contracts have on risk taking in the mutual fund industry using panel
data. The methodology exploits the within-year cross sectional
variation in the performance of mutual funds to identify systematic
time series variation in risk taking. Growth and growth and income
mutual funds in the 1976 to 1993 period are examined. The evidence
suggests that incentive compensation has substantial influence on risk
decisions. A strong seasonal component on average risk is present with
risk reaching a peak in the first quarter of the year. However the
relationship between within-year performance, especially towards
year-end, appears to have changed over time. For losing managers,
excess risk taking appears early in the sample but not in later
years. For winning managers, reductions in risk taking appears towards
year-end in later years but not early in the sample.
Keywords: Risk taking, compensation incentives, mutual fund performance
Full paper (267 KB PDF)
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