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1 February 2014 CFA Institute Journal Review

Strategic Asset Allocation in Money Management (Digest Summary)

  1. Mark K. Bhasin, CFA

To improve the understanding of motivations and tactics in today’s asset management industry, the authors analyze the strategic interaction between two asset managers who are trying to outperform each other to increase their assets under management. Research indicates that fund flows based on relative performance are increasing; thus, a money manager is incentivized to outperform his or her competitors to increase client investor funds and, ultimately, compensation.

What’s Inside?

The authors provide a novel approach to exploring the role of relative wealth concerns in finance by analyzing the risk-taking behavior of two competing risk-averse managers in a tournament-style setting. Their focus is on managers’ strategic interactions, which appear to be strongest when the number of competing managers is small.

They draw the following conclusions: (1) Strategic interactions can generate three different types of equilibrium with materially different risk-taking tendencies—multiple equilibriums, a unique equilibrium, or a mixed-strategy equilibrium; (2) a fund manager remains influenced by tournament incentives despite outperforming a competitor; (3) managers bet in the opposite direction from each other when the performance is too close to establish a clear winner; and (4) changing the correlation between risk assets interacts with tournament incentives because the number and impact of portfolio choices decline as correlations rise substantially. The equilibrium policy of each fund manager is highly dependent on the competitor’s risk profile.

How Is This Research Useful to Practitioners?

The relationship between client funds and relative performance is partially the result of many investors selecting a fund based solely on such published rankings as Morningstar. The authors find that the investing strategy of a fund manager is not constant but rather dependent on his or her risk aversion relative to that of a competing manager. Investors who are concerned about how a particular money manager will trade for his or her account should understand the characteristics of competing managers as well. In addition to its applicability to the analysis of risk-taking behavior of mutual fund and hedge fund managers, the authors’ model may be applied to the behavior of specific traders within a fund or trading team.

How Did the Authors Conduct This Research?

The authors’ theoretical model is based on two risk-averse fund managers in a standard dynamic asset allocation framework. The framework assumes a continuous-time economy for investment opportunities with multiple correlated risk assets. Relative performance is modeled by assuming that client fund flows are dependent on the manager’s investment return compared with the competing manager’s return. The most critical horizon for analyzing investment performance is the calendar year, so risk-taking decisions evolve over the course of the year as relative performance rankings are revealed.

If the manager’s relative performance is above a certain threshold, he or she receives fund flows that increase with performance and thus exhibits relative performance concerns. If the manager performs relatively poorly, he or she receives no flows and his or her objectives are assumed to be comparable with those of a normal manager with no relative concerns. The authors characterize money managers’ behavior by looking at a version of the Nash equilibrium concept in which each manager strategically accounts for the investment policies of the competitor. Although managers cannot observe each other’s positions directly, an analysis of portfolio returns and volatility can give clues to risk-taking decisions. Risk aversion is found to be a very significant factor in much of the analysis, including chasing versus contrarian investing behavior, changes in risk, and equilibrium status.

Abstractor’s Viewpoint

The authors find that the investing behavior of fund managers is critically dependent on the behavior of competing managers as they seek to outperform each other in hopes of attracting greater amounts of client investor funds and compensation. Fund managers are also concerned about relative performance for such psychological reasons as the desire for higher social status or envy, which can lead to investment distortions. Client investors should recognize how money manager risk-taking patterns are strategically affected by interactions with competitors. The authors’ conclusions appear to be consistent with the current research on happiness, which indicates that individual contentment and happiness are critically dependent on the condition of others around the individual.

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