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Risk Management with Benchmarking

  • Suleyman Basak

    ()

    (London Business School and CEPR Institute of Finance and Accounting, Regents Park, London NW1 4SA, United Kingdom)

  • Alex Shapiro

    ()

    (Stern School of Business, New York University, 44 West 4th Street, New York, New York 10012-1126)

  • Lucie Teplá

    ()

    (Finance Department, INSEAD, Boulevard de Constance, 77305 Fontainebleau Cedex, France)

Portfolio theory must address the fact that, in reality, portfolio managers are evaluated relative to a benchmark, and therefore adopt risk management practices to account for the benchmark performance. We capture this risk management consideration by allowing a prespecified shortfall from a target benchmark-linked return, consistent with growing interest in such practice. In a dynamic setting, we demonstrate how a risk-averse portfolio manager optimally under- or overperforms a target benchmark under different economic conditions, depending on his attitude towards risk and choice of the benchmark. The analysis therefore illustrates how investors can achieve their desired performance profile for funds under management through an appropriate combined choice of the benchmark and money manager. We consider a variety of extensions, and also highlight the ability of our setting to shed some light on documented return patterns across segments of the money management industry.

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File URL: http://dx.doi.org/10.1287/mnsc.1050.0476
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Article provided by INFORMS in its journal Management Science.

Volume (Year): 52 (2006)
Issue (Month): 4 (April)
Pages: 542-557

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Handle: RePEc:inm:ormnsc:v:52:y:2006:i:4:p:542-557
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