Hsiu-Lang Chen

DOES PRIOR PERFORMANCE AFFECT A MUTUAL FUND'S CHOICE OF RISK? THEORY AND FURTHER EMPIRICAL EVIDENCE *

Recent empirical studies of mutual fund competition examine the relation between a fund’s performance, the fund manager’s compensation, and the fund manager’s choice of portfolio risk. This paper models a manager’s portfolio choice for compensation rules that can be either a concave, linear, or convex function of the fund’s performance relative to that of a benchmark. For particular compensation structures, a manager increases the fund’s “tracking error” volatility as its relative performance declines. However, declining performance does not necessarily lead the manager to raise the volatility of the fund’s return. The paper presents nonparametric and parametric tests of the relation between mutual fund performance and risk taking for more than 6,000 equity mutual funds over the 1962 to 2006 period. There is a tendency for mutual funds to increase the standard deviation of tracking errors, but not the standard deviation of returns, as their performance declines. This risk-shifting behavior appears more common for funds whose managers have longer tenures.

On Characteristics Momentum

This article investigates whether investors can benefit from information about equity style evolution. The study shows that portfolios formed by firm characteristics such as size, book-to-market, and/or dividend yield can be used to determine investment style dominance. Characteristics momentum, buying stocks with persistent in-favor characteristics and selling stocks with persistent out-of-favor characteristics, conveys valuable information about future stock returns. It is distinct and has longer-lasting effects than price or industry momentum in predicting future returns. In explaining the existence of characteristics momentum profits, this study highlights the importance of slow evolution of changes in firm characteristics. The lifecycle of investment styles can thus have predictive power for trend-chasing investors, who can potentially push up the price of stocks with an in-favor style, and depress the price of stocks with an out-of-favor style.

Style Migration and the Cross-Section of Stock Returns

Stocks experiencing sharp changes in their style characteristics present unique opportunities to examine how investors view style information in making their portfolio allocation decisions. We examine the average returns of such stocks - which we call “style migrants” - and the covariation of the returns of style migrants with their new style cohort stocks to provide new insight into the way investors use equity style information. Our results indicate that investors strongly judge a stock by its style. Specifically, we find that stocks experiencing large levels of variability in their book-to-market and momentum characteristics during the prior three years significantly out perform, during the following year, other stocks with more style stability. In addition, these high style risk stocks covary much more with their new style cohorts than do low style risk stocks that have also moved into the same new style category, consistent with investors overreacting to style shifts of high style risk stocks, while exhibiting a “style memory” effect for low style-risk stocks. In further tests, we find some evidence that high style risk stocks exhibit style return reversals, while low style risk stocks exhibit style return continuations. Overall, our paper provides new evidence about investor behavior by demonstrating that some investors appear to overweight style information when allocating their portfolios, especially for certain high style-risk stocks.