Working Paper: CEPR ID: DP5187
Authors: Suleyman Basak; Alex Shapiro; Lucie Tepl
Abstract: Portfolio theory must address the fact that, in reality, portfolio managers are evaluated relative to a benchmark, and therefore adopt risk management practices to account for the benchmark performance. We capture this risk management consideration by allowing a prespecified shortfall from a target benchmark-linked return, consistent with growing interest in such practice. In a dynamic setting, we demonstrate how a risk averse portfolio manager optimally under- or overperforms a target benchmark under different economic conditions, depending on his attitude towards risk and choice of the benchmark. The analysis therefore illustrates how investors can achieve their desired performance profile for funds under management through an appropriate combined choice of the benchmark and money manager. We consider a variety of extensions, and also highlight the ability of our setting to shed some light on documented return patterns across segments of the money management industry.
Keywords: benchmarking; investments; shortfall risk; tracking error; value-at-risk
JEL Codes: D81; G11; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| benchmark sensitivity (C51) | investment strategy (G11) |
| risk-averse portfolio manager (G11) | performance relative to benchmark (G11) |
| economic conditions (E66) | managerial performance decisions (M54) |
| benchmark selection (C52) | investment strategy effectiveness (G11) |
| benchmark sensitivity (C51) | underperformance in good states (H73) |
| benchmark sensitivity (C51) | overperformance in bad states (D29) |