FIN-02-062 |
NYU Stern School of Business |
Offsetting the Incentives: Risk Shifting, and Benefits of Benchmarking
in Money Management
December 2002
Suleyman Basak, Anna Pavlova and Alex Shapiro
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.
JEL Classification: G11, G20, D60, D81
Suleyman Basak
Institution: London Business School and CEPR Regents Park, London NW1 4SA U.K.
Email: sbasak@london.edu
Telephone: 44 (0) 20 7706-6847
Fax: 44 (0) 20 7724-3317
Anna Pavlova
Institution: Sloan School of Management MIT 50 Memorial Drive, E52-435
Cambridge, MA 02142-1347
Email: apavlova@mit.edu
Telephone: (617) 253-7159
Fax: (617) 258-6855
Alex Shapiro
Institution: Stern School of Business, New York University, 44th West 4th Street, NY 10012
Email: ashapiro@stern.nyu.edu
Telephone: (212) 998-0362
Fax: (212) 995-4233
Homepage: http://www.stern.nyu.edu/~ashapiro/
To download a copy of this paper click here
To request a copy of this paper click here
|