Are fund managers rewarded for taking cyclical risks?

Abstract

The investment fund sector has expanded dramatically since 2008, increasing the capacity for its risk-taking to generate negative spillovers. This paper provides empirical evidence for the existence of wide-spread risk-taking incentives in the investment fund sector, with a particular focus on incentives for synchronized, cyclical risk-taking which could have systemic risk implications. Incentives arise from the positive response of investors to returns achieved through cyclical risk-taking and non-linearities in the relationship between fund returns and fund flows. The fact that market discipline may not be sufficient to ensure prudent behavior among managers creates a clear case for macroprudential regulatory intervention.