Mutual Fund Risk Shifting and Risk Anomalies

Abstract

Risk-shifting by underperforming funds increases their demand for risky stocks. We investigate its contribution to the well known risk anomalies: the apparent overvaluation of stocks with high beta, idiosyncratic volatility, and skewness. We show that these anomalies are concentrated among stocks mainly held by laggard funds. Exploiting the Morningstar methodology change in 2002, whereby its “star” ratings became based on relative performance within a style category rather than across the entire fund universe, we show that the beta anomaly is significant only when beta is measured against the S&P 500 index for the pre-2002 period and against the relevant category index for the post-2002 period. Using a demand system approach we find that removing holdings of the bottom performance quintile of funds substantially reduces the beta anomaly returns.