Risk-taking behavior in mutual fund tournaments

We develop a two-period model of a Brown et al. [J. Finance 51 (1996) 85] mutual fund tournament in which two fund managers with unequal midyear performances compete for new cash inflows. When one of the managers is an exogenous benchmark, winning managers index and losing managers gamble. However, when both managers are active, the winning manager is more likely to gamble-expecially when the midyear performance gap is high or when stocks offer high returns and low volatility. Empirical evidence that winning managers gamble has been documented by other researchers, but it has been interpreted as evidence against the tournament model. With a dataset of weekly returns from 1984 to 1996 for 660 mutual funds, we text for other tournament effects predicted by the model. Our results suggest a role for the theory of tournaments in studies of mutual fund behavior. (C) 2003 Elsevier Science B.V. All rights reserved.