The Cost of Constraints: Risk Management, Agency Theory and Asset Prices
Traditional academic literature has relied on so-called "limits to arbitrage" theories to explain why investment managers are unable to eliminate the effects of investor "irrational" preferences (either the asset-pricing anomalies or the behavioral finance literature) on asset pricing. We demonstrate, however, that investment managers may not eliminate the observed asset-pricing anomalies because they may contribute to their existence. We show that if managers face constraints such as a "tracking-error constraint," coupled with the need to hold liquidity to meet redemptions or to actively-manage investments, they optimally hold higher-volatility securities in their portfolios. Investment constraints, such as tracking-error constraints, however, reduce the principal-agent problems inherent in delegated asset management and serve as effective risk-control tools. Liquidity reserves allow managers to meet redemptions or redeploy risks efficiently. We prove that investment managers will combine a portfolio of active risks (a so-called "alpha portfolio") for a given level of liquidity with a hedging portfolio designed to control tracking error. As the demand for either liquidity or active management increases presumably because of confidence in alpha, the cost of maintaining the tracking-error constraint increases in that the investment managers must finance these demands by selling more lower-volatility securities and holding more higher volatility securities. With more demand for the "alpha" portfolio, managers are forced to buy more of the tracking-error control portfolio. Investment managers and their investors are willing to hold inefficient portfolios and to give up returns, if necessary, to control the tracking-error of their portfolios. Given the liquidity and tracking-error constraints, investment managers concentrate more of their holdings in higher volatility (higher beta) securities. Empirically, we show that active investment managers, such as mutual funds, hold portfolios that concentrate in higher volatility securities. Moreover, when they change their holdings of their "alpha" portfolios (reduce or increase their tracking error by choice), the relative prices of higher volatility stocks change according to the predictions of the model. That is, if investment managers move closer to a market portfolio, the prices of lower-volatility stocks rise more than the prices of higher-volatility stocks given changes in the prices of other market factors.
|Date of creation:||Sep 2013|
|Date of revision:|
|Contact details of provider:|| Postal: |
Phone: (650) 723-2146
Web page: http://gsbapps.stanford.edu/researchpapers/
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Pastor, Lubos & Stambaugh, Robert F., 2003.
"Liquidity Risk and Expected Stock Returns,"
Journal of Political Economy,
University of Chicago Press, vol. 111(3), pages 642-685, June.
- Luboš Pástor & Robert F. Stambaugh, . "Liquidity Risk and Expected Stock Returns," CRSP working papers 531, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
- Lubos Pastor & Robert F. Stambaugh, 2001. "Liquidity Risk and Expected Stock Returns," NBER Working Papers 8462, National Bureau of Economic Research, Inc.
- Pástor, Luboš & Stambaugh, Robert F., 2002. "Liquidity Risk and Expected Stock Returns," CEPR Discussion Papers 3494, C.E.P.R. Discussion Papers.
- Shleifer, Andrei, 2000. "Inefficient Markets: An Introduction to Behavioral Finance," OUP Catalogue, Oxford University Press, number 9780198292272, March.
- Fama, Eugene F & French, Kenneth R, 1995. " Size and Book-to-Market Factors in Earnings and Returns," Journal of Finance, American Finance Association, vol. 50(1), pages 131-55, March.
- Malcolm Baker & Jeffrey Wurgler, 2007.
"Investor Sentiment in the Stock Market,"
NBER Working Papers
13189, National Bureau of Economic Research, Inc.
- Blitz, D.C. & van Vliet, P., 2007. "The Volatility Effect: Lower Risk without Lower Return," ERIM Report Series Research in Management ERS-2007-044-F&A, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam.
- Karceski, Jason, 2002. "Returns-Chasing Behavior, Mutual Funds, and Beta's Death," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(04), pages 559-594, December.
- Kahneman, Daniel & Tversky, Amos, 1979.
"Prospect Theory: An Analysis of Decision under Risk,"
Econometric Society, vol. 47(2), pages 263-91, March.
- Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
- Nicholas Barberis & Ming Huang, 2007.
"Stocks as Lotteries: The Implications of Probability Weighting for Security Prices,"
NBER Working Papers
12936, National Bureau of Economic Research, Inc.
- Nicholas Barberis & Ming Huang, 2008. "Stocks as Lotteries: The Implications of Probability Weighting for Security Prices," American Economic Review, American Economic Association, vol. 98(5), pages 2066-2100, December.
- John H. Cochrane, 2002. "Stocks as Money: Convenience Yield and the Tech-Stock Bubble," NBER Working Papers 8987, National Bureau of Economic Research, Inc.
- Shefrin, Hersh & Statman, Meir, 2000. "Behavioral Portfolio Theory," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 35(02), pages 127-151, June.
- Andrew Ang & Robert J. Hodrick & Yuhang Xing & Xiaoyan Zhang, 2006.
"The Cross-Section of Volatility and Expected Returns,"
Journal of Finance,
American Finance Association, vol. 61(1), pages 259-299, 02.
- Andrew Ang & Robert J. Hodrick & Yuhang Xing & Xiaoyan Zhang, 2004. "The Cross-Section of Volatility and Expected Returns," NBER Working Papers 10852, National Bureau of Economic Research, Inc.
- Ferreira, Miguel A. & Matos, Pedro, 2008. "The colors of investors' money: The role of institutional investors around the world," Journal of Financial Economics, Elsevier, vol. 88(3), pages 499-533, June.
- Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
- Alok Kumar, 2009. "Who Gambles in the Stock Market?," Journal of Finance, American Finance Association, vol. 64(4), pages 1889-1933, 08.
- Jose A. Scheinkman & Wei Xiong, 2003. "Overconfidence and Speculative Bubbles," Journal of Political Economy, University of Chicago Press, vol. 111(6), pages 1183-1219, December.
- Black, Fischer, 1972. "Capital Market Equilibrium with Restricted Borrowing," The Journal of Business, University of Chicago Press, vol. 45(3), pages 444-55, July.
When requesting a correction, please mention this item's handle: RePEc:ecl:stabus:2135. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.