The effect of idiosyncratic risk-taking on mutual fund performance and fees

Casavecchia, L; Hulley, H

The effect of idiosyncratic risk-taking on mutual fund performance and fees

Casavecchia, L

Hulley, H

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Publisher:: Financial Management Association
Publication Type:: Conference Proceeding
Citation:: Financial Management Association 2010 Meetings, 2010, pp. 1 - 50
Issue Date:: 2010-01

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Field	Value	Language
dc.contributor.author	Casavecchia, L https://orcid.org/0000-0003-1452-3059	en_US
dc.contributor.author	Hulley, H https://orcid.org/0000-0002-6684-8309	en_US
dc.contributor.editor	al, AAE	en_US
dc.date	2010-10-20	en_US
dc.date.issued	2010-01	en_US
dc.identifier.citation	Financial Management Association 2010 Meetings, 2010, pp. 1 - 50	en_US
dc.identifier.uri	http://hdl.handle.net/10453/16683
dc.description.abstract	We identify for the first time the crucial role played by idiosyncratic risk as a determinant of performance persistence, flow-performance sensitivity and management fees charged to fund shareholders. Using a sample of US equity mutual funds, we show that high idiosyncratic volatility indirectly captures the aggressiveness of fund investment strategies. We document that funds characterized by high idiosyncratic risk exhibit high probabilities of transitioning into the tails of the performance distribution. In particular, these high transition probabilities in performance cause funds characterized by high idiosyncratic risk to jump more frequently from one tail of the performance distribution to the other, making them appear as if they do not significantly underperform as opposed to funds with low levels of idiosyncratic risk. Consistent with the model of Berk and Green (2004), we argue that idiosyncratic risk is a confusing factor and significantly compromises investors ability to clearly quantify managerial skills. Since investors learn about managerial abilities from past returns and chase performance accordingly, we should expect high noise in performance to reduce the precision of investors priors about these abilities. As a result, in the presence of switching costs and search costs, investors may optimally choose to wait to receive a better signal before (re-) allocating their capital. We document in fact that the sensitivity of flows to performance significantly and monotonically plunges for those funds engaging in high idiosyncratic risk, irrespective of their performance rankings.	en_US
dc.publisher	Financial Management Association	en_US
dc.relation.ispartof	Financial Management Association 2010 Meetings	en_US
dc.relation.ispartof	Financial Management Association Annual Meeting	en_US
dc.title	The effect of idiosyncratic risk-taking on mutual fund performance and fees	en_US
dc.type	Conference Proceeding
utslib.location	New York, USA	en_US
utslib.location.activity	New York, USA	en_US
utslib.for	150103 Financial Accounting	en_US
dc.location.activity	New York, USA	en_US
pubs.embargo.period	Not known	en_US
pubs.organisational-group	/University of Technology Sydney
pubs.organisational-group	/University of Technology Sydney/Faculty of Business
pubs.organisational-group	/University of Technology Sydney/Faculty of Business/Finance Discipline
pubs.organisational-group	/University of Technology Sydney/Strength - QFRC - Quantitative Finance Research Centre
utslib.copyright.status	open_access
pubs.consider-herdc	true	en_US
pubs.place-of-publication	New York, USA	en_US
pubs.start-date	2010-10-20	en_US

Abstract:

We identify for the first time the crucial role played by idiosyncratic risk as a determinant of performance persistence, flow-performance sensitivity and management fees charged to fund shareholders. Using a sample of US equity mutual funds, we show that high idiosyncratic volatility indirectly captures the aggressiveness of fund investment strategies. We document that funds characterized by high idiosyncratic risk exhibit high probabilities of transitioning into the tails of the performance distribution. In particular, these high transition probabilities in performance cause funds characterized by high idiosyncratic risk to jump more frequently from one tail of the performance distribution to the other, making them appear as if they do not significantly underperform as opposed to funds with low levels of idiosyncratic risk. Consistent with the model of Berk and Green (2004), we argue that idiosyncratic risk is a confusing factor and significantly compromises investors ability to clearly quantify managerial skills. Since investors learn about managerial abilities from past returns and chase performance accordingly, we should expect high noise in performance to reduce the precision of investors priors about these abilities. As a result, in the presence of switching costs and search costs, investors may optimally choose to wait to receive a better signal before (re-) allocating their capital. We document in fact that the sensitivity of flows to performance significantly and monotonically plunges for those funds engaging in high idiosyncratic risk, irrespective of their performance rankings.

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http://hdl.handle.net/10453/16683