As fund managers of laggard mutual funds try to catch up with their peers, they tend to pursue high-risk stocks that may give higher than average returns. But in the process, they push the prices of those risky stocks disproportionately higher than what the returns may justify, according to a new research paper by experts at Wharton and elsewhere.

“There is ample evidence showing that fund managers whose performance lags behind the benchmark (or their peer funds) in the first half of the year tend to increase the riskiness of their portfolio in order to catch up by the year-end,” stated the paper, titled “Mutual Fund Risk Shifting and Risk Anomalies.” “We provide evidence that such risk-shifting behavior by underperforming funds has a significant impact on distorting the risk-return trade-off by exerting upward pressure on the prices of riskier stocks.”

The research explored the relationship between risk-shifting by underperforming mutual funds and “risk anomalies” such as subpar risk-adjusted performance of stocks with high market betas, or high volatility. Its sample covered all common stocks listed on the New York Stock Exchange, Nasdaq and the American Stock Exchange from January 1982 to December 2018.

“The fact that the laggard funds will gamble or ramp up risk in order to catch up has been noticed earlier,” said Wharton finance professor Nikolai Roussanov, who co-authored the paper with Xiao Han, finance lecturer at the University of London’s Bayes Business School, and Hongxun Ruan, assistant finance professor at Peking University’s Guanghua School of Management. “Our contribution is to show that this risk-taking behavior by those laggard funds has some serious implications for the resulting pricing of the high-risk stocks in the asset market.”

“We show that it’s not just individuals, but also laggard fund managers who behave in a very high-risk fashion, because they’re trying to gamble for resurrection.” –Nikolai Roussanov

The research also brought clarity to a phenomenon that had puzzled market watchers. “For a long time, it was thought that individual investors that drive this bidding up of meme stocks, and not the institutions. If anything, [the institutions] were seen as taking the other side of these trades,” said Roussanov. Meme stocks like GameStop and AMC saw frenzied trading last February, triggering speculation over increased regulation.

“We show that it’s not just individuals, but also laggard fund managers who behave in this very high-risk fashion, because they’re trying to gamble for resurrection,” Roussanov said. “By doing so, they buy and overpay for high-risk stocks.” Those stocks underperform the benchmark because the fund managers had bought them at elevated prices, he explained. “The key novelty of our work is in showing that this gambling behavior of the laggard funds seems to drive much of the risk anomaly.”

The research showed that high-risk stocks underperform or deliver inferior risk-adjusted returns, on average. “Once you adjust for their riskiness, it looks like you’re better off investing in low-risk stocks — the boring stocks — than the more exciting, high-volatility, high-beta, move-the-market stocks,” said Roussanov. “Eventually, the high-risk stocks come crashing down. If you look over long stretches of time, it’s the boring, low-volatility, low-beta stocks that tend to outperform on a risk-adjusted basis.”

Ratings Reform

The researchers found evidence of risk-shifting by underperforming funds and its impact on anomaly returns in data from Morningstar, whose ratings are widely used in the mutual funds industry. They compared the performance of funds before and after June 2002, when Morningstar had changed its methodology from pooling and ranking all funds together to reclassifying them by “style,” defined as a combination of value/growth metrics and market capitalization. The new order grouped funds under four categories — Large Value, Large Growth, Small Value, and Small Growth. That change enabled comparisons of fund performance across those categories.

The risk-shifting by laggard funds was apparent in comparing the pre- and post-2002 data. While the study found “a significant beta anomaly” among S&P 500 index stocks held by underperforming funds in the pre-2002 period, it did find the reverse following the ratings reform: “The S&P 500 beta anomaly disappears, and a category-beta anomaly emerges.”

“After 2002, the high-risk anomaly shows up within each style category,” said Roussanov. “For example, within Large Value stocks, you see that highly volatile, high-beta value stocks underperform.”

The study found corroboration of that behavior elsewhere, too: “Funds that underperformed their peers invest more in stocks with higher exposures to the relevant Russell index, which is a common benchmark for funds in the same category.”

Other risk-related anomalies, including apparent overpricing (revealed by subsequent underperformance) of stocks with high idiosyncratic volatility, high skewness, or “lottery-like” return distributions are also largely concentrated among funds that underperform their relevant peer groups, the paper noted.

“If you look over long stretches of time, it’s the boring, low-volatility, low-beta stocks that tend to outperform on a risk-adjusted basis.” –Nikolai Roussanov

The study found laggard funds across all categories, although large funds tend not to have big swings in performance, Roussanov noted. “With the rise of index funds in the last 20 years, many institutions don’t adjust their holdings in stocks very much and are passive. It’s the active funds that matter because they’re sensitive to prices — they’re trading in and out.” The risk-shifting behavior of even small funds matters because “they’re still important in driving prices of those risky stocks,” he added.

Timely Focus on Market Efficiency

Roussanov said the researchers’ findings are timely and significant in the interests of “market efficiency” in an environment where large institutions manage more and more capital but are generally passive investors. The resulting space allows a free rein for smaller but more active funds to distort the risk-return equation by overpaying for risky stocks.

“The biggest incentive for fund managers is to get more assets under management,” Roussanov continued. “You get more assets under management if you have good ratings vis-a-vis your competition — other funds that follow the same benchmark. What they all fight for is inflows.” The chase for good ratings drives laggard fund managers to pursue short-term returns at the expense of efficient price discovery, he explained.

“If a stock is overvalued, it will eventually come down, but who is there to take the other side of the trade to correct it?” Roussanov asked. “We think that there are enough smart investors, hedge funds and mutual funds doing that. But the reality is that the incentives are not always aligned for some of them to do the right thing.”

Roussanov explained how those misaligned incentives play out and distort prices. “If you are a mutual fund manager who needs to beat the benchmark, you’re less likely to go and buy an undervalued stock that will not help you to beat the benchmark. You’re more likely to choose the next GameStop or whatever it is that will help you catch up. The incentive is sometimes to risk-shift to game the benchmark.”