Mutual fund tournaments, style drift and active returns

Abstract

In this thesis, I investigate the effect of annual fund tournaments on intra-year style drift (tournament-induced style drift) as well as its immediate effect on the fund's year-end active return (volatility). Based on a large sample of 2,194 active U.S. equity funds with a specific style from 2003 to 2014, I find the relation between style drift and tournament rank is convex, with funds appearing in the top and bottom performance quartiles having higher subsequent style drift. This finding is consistent with the convex flow-performance relation identified by Chevalier and Ellison (1997). I also document the first evidence on tournament-induced style drift. Funds in the top quartile of the mid-year tournament ranking (interim tournament winners) reduce their style drift in the latter half of the year. Conversely, funds in the bottom quartile of the mid-year tournament ranking (interim tournament losers) increase their style drift in the second half of the year. This finding suggests that style drift is a short-run behavior affected by tournament rankings. Examination of the performance effect of style drift shows that it leads to economically significant higher active return volatility. However, its effect on active return is economically insignificant. Style drift in the second half of the year by interim tournament winners and losers also have economically insignificant effect on year-end active return. Therefore, style-shifting does not create value for investors, just more risk. By viewing style drift in the context of annual fund tournaments, I shed light on the driver of style drift and its immediate consequences on the fund's active return (volatility). The results of this thesis suggest that mutual fund investors must consider style consistency together with performance when selecting funds.