Competition among Portfolio Managers and Asset Specialization
44 Pages Posted: 4 Mar 2010 Last revised: 9 Aug 2017
Date Written: September 1, 2015
This paper develops a tractable dynamic model of competition between two risk-averse portfolio managers who attempt to outperform each other by trading in different stocks, reflecting asset specialization. We characterize explicitly the unique Nash equilibrium portfolio policies, and show that a risk tolerant manager decreases, and a risk intolerant increases, her portfolio risk due to competition. Contrary to the standard result without competition, a higher risk aversion could well incentivize more risk taking. We also show that competition can be conducive to asset specialization, and hence under-diversification, in that both managers, when risk tolerant, prefer to restrict their investment sets to avoid competing on the same turf by trading in the same set of stocks. Such under-diversification could impose substantial costs on the managers' client investors. The clients also lose when the risk-return profile of their investments deviates from the optimal level due to managerial turnover or changing stock characteristics. The client's loss is higher when it is her manager who is replaced rather than the other manager. But surprisingly that loss is the same whether a given change in stock characteristics applies to her manager's stock or to the competitor's stock to which she has no direct exposure.
Keywords: Competition, Portfolio Choice, Asset Specialization, Under-Diversification, Cost-Benefit Analysis, Relative Performance
JEL Classification: G11, G20, D81, C73, C61
Suggested Citation: Suggested Citation