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

Suleyman Basak, Anna Pavlova and Alex Shapiro

No 5006, 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 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 (search for similar items in EconPapers)
JEL-codes: D60 D81 G11 G20 (search for similar items in EconPapers)
Date: 2005-04
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 (11)

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Related works:
Working Paper: Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management (2004)
Working Paper: Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management (2003)
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