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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/27294
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| Title: | Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in
Money Management |
| Authors: | Basak, Suleyman
Pavlova, Anna
Shapiro, Alex |
| Keywords: | Fund Flows
Implicit Incentives
Risk Taking
Benchmarking
Risk Management
Portfolio Choice |
| Issue Date: | Dec-2003 |
| Series/Report no.: | FIN-03-049 |
| 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. |
| URI: | http://hdl.handle.net/2451/27294 |
| Appears in Collections: | Finance Working Papers
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