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http://hdl.handle.net/2451/26506
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| Title: | Offsetting the Incentives: Risk Shifting, and Benefits of Benchmarking
in Money Management |
| Authors: | Basak, Suleyman
Pavlova, Anna
Shapiro, Alex |
| Issue Date: | Dec-2002 |
| Series/Report no.: | FIN-02-062 |
| Abstract: | Money managers are rewarded for increasing the value of assets under
management, and predominately so in the mutual fund industry. This
compensation scheme gives the manager an implicit incentive to exploit
the well-documented positive fund-flows to relative-performance
relationship by manipulating her risk exposure. It also provides her
with an explicit incentive to manage the fund in accordance with her own
appetite for risk. In a dynamic asset allocation framework, we show that
as the year-end approaches, the interplay of these incentives induces
the manager to optimally closely mimic the index, relative to which her
performance is evaluated, when the fund's year-to-date return is just
sufficient to cause a higher expected flow. As she falls behind, she
gradually increases her risk exposure (via leverage or short selling),
reaching an extremum at a critical level of underperformance. This
policy results in economically significant deviations from investor's
desired risk exposure, substantially impairing them. To better align
investors' and managers' incentives, investors or regulators can impose
a benchmarking restriction on the fund manager, prohibiting a shortfall
relative to a certain reference portfolio to exceed a pre-specified
level. The restriction tempers deviations from the investors' desired
risk exposure in the states in which the manager is tempted to deviate
the most, and hence is beneficial. The analysis reveals how this risk
management restriction should be designed for the highest benefit to the
investors. Our findings complement and refine results in the related
literature on risk taking incentives of mutual fund managers, and are at
odds with previous work arguing against benchmarking. |
| URI: | http://hdl.handle.net/2451/26506 |
| Appears in Collections: | Finance Working Papers
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