Risk Shifting and Mutual Fund Performance

Mutual funds change their risk levels significantly over time. Risk shifting might be caused by ill-motivated trades of unskilled or agency-prone fund managers who trade to increase their personal compensation. Alternatively, risk shifting might occur when skilled fund managers trade to take advantage of their stock selection and timing abilities. This article investigates the performance consequences of risk shifting and sheds light on the mechanisms and the economic motivations behind risk-shifting behavior. Using a holdings-based measure of risk shifting, we find that funds that increase risk perform worse than funds that keep stable risk levels over time, suggesting that risk shifting either is an indication of inferior ability or is motivated by agency issues.