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

42 Pages Posted: 5 May 2003  

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 2003

Abstract

Money managers are rewarded for increasing the value of assets under management, and predominantly so in the mutual fund industry. This gives the manager an implicit incentive to exploit the well-documented positive fund-flows to relative-performance relationship by manipulating her risk exposure. In a dynamic portfolio framework, we show that as the year-end approaches, the ensuing convexities in the manager's objective induce her to closely mimic the index, relative to which her performance is evaluated, when the fund's year-to-date return is sufficiently high. As her relative performance falls behind, she chooses to deviate from the index by either increasing or decreasing the volatility of her portfolio. The maximum deviation is achieved at a critical level of underperformance. It may be optimal for the manager to reach such deviation via selling the risky asset despite its positive risk premium. Under multiple sources of risk, with both systematic and idiosyncratic risks present, we show that optimal managerial risk shifting may not necessarily involve taking on any idiosyncratic risk. Costs of misaligned incentives to investors resulting from the manager's policy are economically significant. We then demonstrate how a simple risk management practice that accounts for benchmarking can ameliorate the adverse effects of managerial incentives.

Keywords: Fund Flows, Implicit Incentives, Risk Taking, Benchmarking, Risk Management, Portfolio Choice

JEL Classification: G11, G20, D60, D81

Suggested Citation

Basak, Suleyman and Pavlova, Anna and Shapiro, Alex, Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management (December 2003). MIT Sloan Working Paper No. 4303-03; NYU Finance Working Paper; EFA 2003 Annual Conference Paper No. 269; AFA 2005 Philadelphia Meetings. Available at SSRN: https://ssrn.com/abstract=403140 or http://dx.doi.org/10.2139/ssrn.403140

Suleyman Basak

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
44 (0)20 7000 8256 (Phone)
44 (0)20 7000 8201 (Fax)

HOME PAGE: http://www.suleymanbasak.com

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Anna Pavlova (Contact Author)

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)

77 Bastwick Street
London, EC1V 3PZ
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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