Fund Flows, Performance, Managerial Career Concerns, and Risk Taking

We develop a framework in which we simultaneously model the interactions among investors, fund companies (represented by fund advisors), and managers. In this framework, we show that the interplay between a manager's incentives arising from her compensation structure and career concerns leads to a non-monotonic (approximately U-shaped) relation between her risk choices and prior performance relative to her peers. We empirically analyze the risk-taking behavior of a large sample of fund managers and find significant support for the predicted U-shaped relative risk-prior performance relation. Reputation concerns and employment risk plays a crucial role in driving the non-monotonic relation; significant out performers (under performers) are less (more) likely to be fired in the future, and are also more likely to increase relative risk. We also show empirical support for the additional testable implications of the theory that link determinants of the fund flow-performance relation and managerial career concerns to risk-taking behavior. Funds with higher expense ratios have less convex fund flow-performance relations and less convex U-shaped relative risk-prior performance relations. Funds with younger managers, who face greater employment risk, have more convex U-shaped relative riskprior performance relations.