Optimal Asset Allocation and Risk Shifting in Money Management
40 Pages Posted: 30 Jan 2006
There are 3 versions of this paper
Optimal Asset Allocation and Risk Shifting in Money Management
Optimal Asset Allocation and Risk Shifting in Money Management
Optimal Asset Allocation and Risk Shifting in Money Management
Date Written: May 2006
Abstract
This paper investigates a fund manager's risk-taking incentives induced by an increasing and convex fund-flows to relative-performance relationship. 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: G11, G20, D60, D81
Suggested Citation: Suggested Citation
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