Are Venture Capital Firms and Hedge Funds Safer Than Mutual Funds?

Abstract

The authors observe that mutual funds compete in tournaments based on rank, with investors allocating new money only into top ones and ignoring the rest. They then suggest that losing managers play go-for-broke in order to place high in the contest. They note that, in contrast, venture capital firms and hedge funds compete based on risk-adjusted performance. Thus, they argue that investors' behavioral biases matter more in the alternative asset world. In particular, they feel that investors' loss aversion influences a fee-maximizing manager. It causes a losing manager to scale down risk and a winning one take some. They argue that this provides a risk-mitigating safety valve which is absent in the performance-obscuring tournament, suggesting that there may be more risk in that “tournament” mutual fund environment than in the alternative asset sphere.