RFS Advance Access originally published online on June 21, 2007
Review of Financial Studies 2007 20(5):1583-1621; doi:10.1093/rfs/hhm026
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Optimal Asset Allocation and Risk Shifting in Money Management
London Business School and CEPR
London Business School and CEPR
Stern School of Business, New York University
Address correspondence to Suleyman Basak, London Business School, Regents Park, London NW1 4SA, UK, or e-mail: sbasak{at}london.edu
G11, G20, D60, D81
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Abstract |
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This article investigates a fund manager's risk-taking incentives induced by an increasing and convex relationship of fund flows to relative performance. 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.
We are grateful to Robert McDonald (the editor) and two anonymous referees for valuable suggestions. We would also like to thank colleagues at MIT Sloan, NYU Stern, and LBS, and especially Denis Gromb, Roberto Rigobon, and Antoinette Schoar, as well as Joe Chen, Glenn Ellison, Mike Gallmeyer, David Musto, Brad Paye, Ludovic Phalippou, Paola Sapienza, Kari Sigurdsson, Lucie Tepla, Peter Tufano, Dimitri Vayanos, and the seminar participants at Bank Gutmann, Bank of England, BI, Bilkent, Copenhagen, Harvard, HEC, LBS, LSE, MIT, NHH, NYU, Northwestern, Rutgers, UCD, UCLA, UNC, USI Lugano, Washington St. Louis, Yale, ASAP conference, American Finance Association, Blaise Pascal International Conference, European Finance Association, and Econometric Society winter meetings for their comments. Special thanks to Martijn Cremers. We also thank Pavitra Kumar, Dmitry Makarov, Juha Valkama, and Jialan Wang who provided excellent research assistance. Parts of this work are drawn from the paper that was previously circulated under the title "Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management" (2005, CEPR DP 5006). Research support from the Q Group is gratefully acknowledged. We are indebted to Will Goetzmann, Geert Rouwenhorst, and the International Center for Finance at Yale SOM for kindly providing the data. All errors are solely our responsibility.