| dc.description |
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 asset allocation
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. The manager's policy results in economically significant departures
from investors' desired risk exposure. We then demonstrate how constraining the
manager's investment opportunity set, via a simple benchmarking restriction, can
ameliorate the adverse effects of managerial incentive |
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