The Efficiency of Mutual Fund Competition and Compensation System—An Empirical Study Based on Tournaments

When fund managers are faced with dual agency conflicts of hiding efforts and taking risks, a tournament scheme which is based on relative performance and removes bottom ranked managers can help investors to select and stimulate fund managers. Using mutual fund equity holding data from 2004—2009, this study examines how tournaments among mutual fund managers affect managers’ trading strategy and fund performance. The empirical results show that the degree of activeness is correlated with the degree of competition and compensation, but is independent with fund managers’ stock selection ability. Lower ranked fund managers are more likely to take aggressive strategy in order to change their ranking position, but on average, these fund managers do not have stock selection abilities and fail to deliver positive returns to investors. The results suggest that when qualified fund managers are in short, a simple tournament scheme can not help select capable fund managers, while high incentives increase investors’ costs and risks.