Working Paper

Compensation incentives and risk taking behavior: evidence from mutual funds

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 paneldata. 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.

Status: Published in Risk measurement and systemic risk: joint central bank research conference (1995: November 16-17)

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 1996

Number: 96-21