| This dissertation examines the relationship between a mutual fund's past performance and its growth, as well as the effects of a fund manager's past performance on his optimal portfolio risk level.;A strong, positive correlation between a mutual fund's performance and its subsequent growth is found. Returns up to five years in the past are found to affect a fund's growth rate. Positive increments in growth are associated with crossing certain benchmark performance percentiles.;The dependence between a fund's performance and its growth creates an implicit contract in which the management fee is affected not only by a manager's performance in the current period but also by his prior performance. In particular, increases in the rate of new investment in a fund induced when fund performance exceeds a particular hurdle rate will create a performance bonus in the management fee function. Ex ante, the bonus is similar to a call option on the fund's portfolio. It is shown that the optimal portfolio risk level in the second period of a two period model depends on how the manager's performance in the first period has affected the value of bonuses in the management fee. In general, a manager with good past performance will become conservative, while a manager with poor past performance will become aggressive. Simulations are performed to show that the model's predictions are robust to changes in the economic environment and fee structure. Empirical tests of the hypothesis that a fund's risk level is independent of its past performance are also conducted. The overall test results support the implications of our model. |
