Optimal Asset Allocation and Risk Shifting in Money Management

Suleyman Basak, Anna Pavlova and Alex Shapiro

No 5524, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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 choice framework, we show that the ensuing convexities in the manager's objective give rise to a finite risk-shifting range over which she gambles to finish ahead of her benchmark. Such gambling entails either an increase or a decrease in the volatility of the manager's portfolio, depending on her risk tolerance. In the latter case, the manager reduces her holdings of the risky asset despite its positive risk premium. Our empirical analysis lends support to the novel predictions of the model. 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 demonstrated to be economically significant.

Keywords: Fund flows; Implicit incentives; Risk taking; Relative performance; Risk management; Portfolio choice (search for similar items in EconPapers)
JEL-codes: D60 D81 G11 G20 (search for similar items in EconPapers)
Date: 2006-03
New Economics Papers: this item is included in nep-fin, nep-fmk and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (12)

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Journal Article: Optimal Asset Allocation and Risk Shifting in Money Management (2007)
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