Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management
Suleyman Basak, London Business School and CEPR
Anna Pavlova, MIT
Alex Shapiro, New York University

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.

This research shows how managers who are subject to convexities in their compensation may manipulate their portfolios exposure to risk to maximize their own utility, which may adverse to the interests of their clients. The results will interest our members who need to better understand these incentives, either because they face them or because the provide them. The results will also interest members whose trading strategies might benefit from being able to predict how other managers will adjust their risk exposure.