Funds Managers' Risk Tolerance vis-a-vis Ability: Market Structure Implications
61 Pages Posted: 16 Aug 2017 Last revised: 29 Jun 2021
Date Written: December 19, 2020
Abstract
Suppose funds managers are differentiated by innate ability at some origin point in time. Suppose also that funds managers are homogeneous with respect to risk tolerance. Regardless of continuity of the continuum for asset risk, the continuum of risk-return trade-offs that is available to funds managers is shown to be endogenously and rigidly segmented into continuums of `safe', and `innovative' assets. Stated endogenous rigid segmentation is shown to induce a U-shaped return generating function (equivalently, topology) for either of native or expected returns, with outcome the universe of fund performance is characterized by a U-shaped return distribution. The resulting U-shaped return distribution, which cannot be rationalized by heterogeneity of risk tolerance, resolves an empirical anomaly - the finding that index funds (safe funds) perform about as well as actively managed funds (innovative funds). In aggregate, while the risk tolerance paradigm casts funds managers as competing primarily with reference to assets' native return potential, the ability paradigm casts funds managers as competing primarily with reference to capacity for right interpretation of information for conditioning of asset expected returns. We arrive then at optimality of conditioning of funds managers' compensation on fund size, as opposed to fund performance.
Keywords: Venture Capital, Mutual Funds, U-shaped Distribution, Safe Assets, Innovative Assets, Fund Alpha
JEL Classification: G11, G24
Suggested Citation: Suggested Citation