Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management
Abstract
Money managers are rewarded for increasing the value of assets under management, and predominantly so in the mutual fund industry. This gives the manager an implicit incentive to exploit the well-documented positive fund-flows to relative-performance relationship by manipulating her risk exposure. In a dynamic asset allocation framework, we show that as the year-end approaches, the ensuing convexities in the manager's objective induce her to closely mimic the index, relative to which her performance is evaluated, when the fund's year-to-date return is sufficiently high. As her relative performance falls behind, she chooses to deviate from the index by either increasing or decreasing the volatility of her portfolio. The maximum deviation is achieved at a critical level of underperformance. It may be optimal for the manager to reach such deviation via selling the risky asset despite its positive risk premium. Under multiple sources of risk, with both systematic and idiosyncratic risks present, we show that optimal managerial risk shifting may not necessarily involve taking on any idiosyncratic risk. The manager's policy results in economically significant departures from investors' desired risk exposure. We then demonstrate how constraining the manager's investment opportunity set, via a simple benchmarking restriction, can ameliorate the adverse effects of managerial incentiveDownload Info
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Paper provided by Massachusetts Institute of Technology (MIT), Sloan School of Management in its series Working papers with number 4303-03.Length:
Date of creation: 23 May 2003
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Handle: RePEc:mit:sloanp:3514
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Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA
Related research
Keywords: Fund Flows; Implicit Incentives; Risk Taking; Benchmarking; Risk Management; Investments;Other versions of this item:
- Alex Shapiro & Suleyman Basak & Anna Pavlova, 2004. "Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management," Econometric Society 2004 North American Winter Meetings 583, Econometric Society.
- Basak, Suleyman & Pavlova, Anna & Shapiro, Alex, 2005. "Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management," CEPR Discussion Papers 5006, C.E.P.R. Discussion Papers.
- D60 - Microeconomics - - Welfare Economics - - - General
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G20 - Financial Economics - - Financial Institutions and Services - - - General
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Citations
Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.Cited by:
- Jackwerth, Jens Carsten & Hodder, James E., 2006.
"Incentive Contracts and Hedge Fund Management,"
MPRA Paper
11632, University Library of Munich, Germany.
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