Time-varying incentives in the mutual fund industry

In this paper, the authors provide evidence that the convexity of the flow-performance relationship in the mutual fund industry varies with economic activity. This effect is strongly economically significant: a +/-1% change in GDP growth doubles/eliminates the degree of convexity of the flow-performance relationship. The effect of economic activity dominates that of market conditions and can be rationalized by the behavior of investors who smooth consumption while displaying a disposition effect. Our finding has two major implications: first, it rationalizes the risk-shifting behavior of mutual fund managers and provides support for the seminal flow-based tournament hypothesis over the more recent "career concern" explanation. Second, it explains why mutual fund performance varies with the business cycle.