FIN-03-048 |
NYU Stern School of Business |
December 2003
Suleyman Basak, Alex Shapiro and Lucie Tepla
ABSTRACT
Portfolio theory must address the fact that, in reality, portfolio
managers are evaluated relative to a benchmark, and therefore adopt
risk management practices to account for the benchmark performance.
We capture this risk management consideration by allowing a
pre-specified shortfall from a target benchmark-linked return,
consistent with growing interest in such practice. In a dynamic
setting, we demonstrate how a risk averse portfolio manager optimally
under- or over-performs a target benchmark under different economic
conditions, depending on his attitude towards risk and choice of the
benchmark. The analysis therefore illustrates how investors can
achieve their desired gain/loss characteristics for funds under
management through an appropriate combined choice of the benchmark
and money manager. We consider a variety of extensions, and also
highlight the ability of our setting to shed some light on documented
return patterns across segments of the money management industry.
Suleyman Basak
Institution: London Business School, Regent’s Park, London - NW1 4SA, UK
Phone: +44 (0) 20-7706-6847
Fax: +44 (0) 20-7724-3317
Email: sbasak@london.edu
Alex Shapiro
Institution: Stern School of Business, New York University
Phone: (212) 998-0362
Fax: (212) 995-4233
Email: ashapiro@stern.nyu.edu
Home Page: http://www.stern.nyu.edu/~ashapiro
Lucie Tepla
Institution: Finance Department, INSEAD, Boulevard de Constance,
77305 Fountainebleau Cedex, France
Phone: (33) 1-6072-4485
Fax: (33) 1-6072-4045
Email: lucie.tepla@insead.edu
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