FIN-03-049 |
NYU Stern School of Business |
December 2003
Suleyman Basak, Anna Pavlova and Alex Shapiro
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.
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
Anna Pavlova
Institution: Sloan School of Management, MIT 50 Memorial Drive, E52-435
Cambridge, MA 02142-1347
Phone: (617) 253-7159
Fax: (617) 258-6855
Email: apavlova@mit.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
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