Offsetting the Incentives: Risk Shifting, and Benefits of Benchmarking in Money Management

33 Pages Posted: 13 Nov 2008

See all articles by Suleyman Basak

Suleyman Basak

London Business School; Centre for Economic Policy Research (CEPR)

Anna Pavlova

London Business School; Centre for Economic Policy Research (CEPR)

Alex Shapiro

New York University (NYU) - Department of Finance

Multiple version iconThere are 6 versions of this paper

Date Written: December 2002

Abstract

Money managers are rewarded for increasing the value of assets under management, and predominately so in the mutual fund industry. This compensation scheme gives the manager an implicit incentive to exploit the well-documented positive fund-flows to relative-performance relationship by manipulating her risk exposure. It also provides her with an explicit incentive to manage the fund in accordance with her own appetite for risk. In a dynamic asset allocation framework, we show that as the year-end approaches, the interplay of these incentives induces the manager to optimally closely mimic the index, relative to which her performance is evaluated, when the fund's year-to-date return is just sufficient to cause a higher expected flow. As she falls behind, she gradually increases her risk exposure (via leverage or short selling), reaching an extremum at a critical level of underperformance. This policy results in economically significant deviations from investor's desired risk exposure, substantially impairing them. To better align investors' and managers' incentives, investors or regulators can impose a benchmarking restriction on the fund manager, prohibiting a shortfall relative to a certain reference portfolio to exceed a pre-specified level. The restriction tempers deviations from the investors' desired risk exposure in the states in which the manager is tempted to deviate the most, and hence is beneficial. The analysis reveals how this risk management restriction should be designed for the highest benefit to the investors. Our findings complement and refine results in the related literature on risk taking incentives of mutual fund managers, and are at odds with previous work arguing against benchmarking.

Suggested Citation

Basak, Suleyman and Pavlova, Anna and Shapiro, Alex, Offsetting the Incentives: Risk Shifting, and Benefits of Benchmarking in Money Management (December 2002). NYU Working Paper No. SC-AM-02-12. Available at SSRN: https://ssrn.com/abstract=1300820

Suleyman Basak (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
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44 (0)20 7000 8256 (Phone)
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HOME PAGE: http://www.suleymanbasak.com

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Anna Pavlova

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
+44 20 7000 8218 (Phone)

HOME PAGE: http://faculty.london.edu/apavlova

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Alex Shapiro

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0362 (Phone)
212-995-4233 (Fax)

HOME PAGE: http://www.stern.nyu.edu/~ashapiro/

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