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

Suleyman Basak, Anna Pavlova and Alex Shapiro

No 4303-03, Working papers from Massachusetts Institute of Technology (MIT), Sloan School of Management

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 asset allocation 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. The manager's policy results in economically significant departures from investors' desired risk exposure. We then demonstrate how constraining the manager's investment opportunity set, via a simple benchmarking restriction, can ameliorate the adverse effects of managerial incentive

Keywords: Fund Flows; Implicit Incentives; Risk Taking; Benchmarking; Risk Management; Investments (search for similar items in EconPapers)
Date: 2003-05-23
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8)

Downloads: (external link)
http://hdl.handle.net/1721.1/3514 (application/pdf)

Related works:
Working Paper: Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management (2005)
Working Paper: Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management (2004)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:mit:sloanp:3514

Ordering information: This working paper can be ordered from
MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA

Access Statistics for this paper

More papers in Working papers from Massachusetts Institute of Technology (MIT), Sloan School of Management MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA. Contact information at EDIRC.
Bibliographic data for series maintained by None ( this e-mail address is bad, please contact ).