Most mutual fund managers have performance-based contracts. Our theory predicts that mutual fund managers with asymmetric contracts and mid-year performance close to their announced benchmark increase their portfolio risk in the second part of the year. As predicted by our theory, performance deviation from the benchmark decreases risk-shifting only for managers with performance contracts. Deviation from the benchmark dominates incentives from the flow-performance relation, suggesting that risk-shifting is motivated more by management contracts than by a tournament to capture flows.

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In this paper, we introduce a conditional measure of skill, the correlation between funds’ residual trades, net of common trading motives, and future news about the stocks traded. Using this measure, we show that the average mutual fund manager in the cross-section has stock-picking skill. This result is robust to different benchmarks and is mainly driven by the manager’s ability to predict a firm’s cash-flow news. This skill has short-term persistence and is distinctly related to traditional measures of performance. Importantly, consistent with Berk and Green [2004, Mutual Fund Flows and Performance in Rational Markets, Journal of Political Economy 112(6), 1269–1295], fund flows are increasing with respect to managerial skill after controlling for fund performance.

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