Optimal Asset Allocation and Risk Shifting in Money Management

44 Pages Posted: 14 Jun 2006

See all articles by Suleyman Basak

Suleyman Basak

London Business School; Centre for Economic Policy Research (CEPR)

Anna Pavlova

London Business School; Centre for Economic Policy Research (CEPR)

Alex Shapiro

New York University (NYU) - Department of Finance

Multiple version iconThere are 3 versions of this paper

Date Written: March 2006

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 choice framework, we show that the ensuing convexities in the manager's objective give rise to a finite risk-shifting range over which she gambles to finish ahead of her benchmark. Such gambling entails either an increase or a decrease in the volatility of the manager's portfolio, depending on her risk tolerance. In the latter case, the manager reduces her holdings of the risky asset despite its positive risk premium. Our empirical analysis lends support to the novel predictions of the model. 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 demonstrated to be economically significant.

Keywords: Fund flows, implicit incentives, risk taking, relative performance, risk management, portfolio choice

JEL Classification: D60, D81, G11, G20

Suggested Citation

Basak, Suleyman and Pavlova, Anna and Shapiro, Alex, Optimal Asset Allocation and Risk Shifting in Money Management (March 2006). CEPR Discussion Paper No. 5524, Available at SSRN: https://ssrn.com/abstract=908851

Suleyman Basak (Contact Author)

London Business School ( email )

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HOME PAGE: http://www.suleymanbasak.com

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Anna Pavlova

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
+44 20 7000 8218 (Phone)

HOME PAGE: http://https://www.anna-pavlova.co.uk/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Alex Shapiro

New York University (NYU) - Department of Finance ( email )

Stern School of Business
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New York, NY 10012-1126
United States
212-998-0362 (Phone)
212-995-4233 (Fax)

HOME PAGE: http://www.stern.nyu.edu/~ashapiro/