Performance-Based Fees and Risk Shifting With the Knockout Barrier

Journal of Investment Management, Vol. 5, No. 3, Third Quarter 2007

Posted: 22 Oct 2007

See all articles by Xiaodong Xu

Xiaodong Xu

Northwestern University - Department of Industrial Engineering and Management Sciences

Bernd Scherer

EDHEC Business School - Department of Economics & Finance

Abstract

Many investment firms reward portfolio managers based on their performance. This article investigates a manager's optimal active risk policy using stochastic programming techniques. Our multiple-period model incorporates the most common incentive-fee structures, and captures the risk that the manager is fired for underperformance. In contrast to single-stage models, the manager shows remarkable prudence as he strives to safeguard future fee flows. We observe that if the client is too intolerant of underperformance, the manager will be incentivized to reduce active risk despite earning active fees. We also observe that capping fees too early will causes a lock-in effect.

Keywords: Performance fees, risk shifting, options, knockout barrier, stochastic programming

Suggested Citation

Xu, Xiaodong and Scherer, Bernd, Performance-Based Fees and Risk Shifting With the Knockout Barrier. Journal of Investment Management, Vol. 5, No. 3, Third Quarter 2007, Available at SSRN: https://ssrn.com/abstract=1023700

Xiaodong Xu (Contact Author)

Northwestern University - Department of Industrial Engineering and Management Sciences ( email )

Evanston, IL 60208-3119
United States

Bernd Scherer

EDHEC Business School - Department of Economics & Finance ( email )

France

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