Chasing hot funds: The effects of relative performance on portfolio choice

We study the way in which SEC restrictions on fund manager compensation aff ect portfolio choice when investors buy into funds whose recent performance has been good. We find that fund managers choose riskier portfolios than t hey would if there were no contracting restrictions and that these portfoli os are riskier than the optimal risky portfolio. Further, if investors choo se funds according to performance rank rather than Performance relative to the average, these effects are exacerbated-fund managers choose even riskie r portfolios. Thus, our analysis suggests a need to provide investors with information about risk-adjusted performance.