A noted observer of the mutual fund industry once commented, “The real business of money management is not managing money, it is getting money to manage.” This seems truer than ever in today’s difficult markets because investors are extremely cautious. Such wariness is an incentive to investment fund managers, who want to outperform their peers because doing so is likely to attract investors, increase the assets under their management and, hence, their compensation. It’s also an incentive for a manager to find his fund touted in publications such as Investors Chronicle. The question is how this desire to outperform other funds translates into the portfolio strategies of money managers.
To discover the answer, Suleyman Basak, Professor of Finance at London Business School, and Dmitry S. Makarov, Assistant Professor of Finance at the New Economic School (Moscow), have been examining the strategic interaction between two risk-averse managers in a continuoustime setting through the lens of game theory. Their aim is to determine how managers’ goals distort the allocation of assets they manage.
Basak and Makarov explain that the effects of strategic considerations are likely to be the strongest when a small number of funds are competing against one another, such as a situation in which several top-performing funds compete for leadership. To show how this works, they consider two riskaverse money managers (interpreted as mutual fund managers, hedge fund managers or simply traders). Analysing the managers’ behaviour, they turn to game theory (specifically the Nash equilibrium concept) in which each manager strategically accounts for the dynamic investment policies of the other manager and the equilibrium policies of the two managers are mutually consistent.
The authors’ complex analysis begins by presenting the economic setup and money flows justification for relative performance concerns. They proceed to describe the managers’ objective functions and characterise their best responses. After that, they analyse such issues as the nonexistence, uniqueness and multiplicity of equilibrium. Finally, they investigate the properties of the equilibrium investment policies followed.
They conclude that managers’ equilibrium policies are driven by both chasing and contrarian behaviours whenever either manager substantially outperforms the opponent. By contrast, they found that managers engage in gambling behaviour when their performances are close to a well-defined threshold. Depending on the stock correlation, the direction of gambling for a given manager may differ across stocks; however, the two managers always gamble strategically in the opposite direction from each other in each individual stock.
The authors also note some promising directions for future research, such as cases in which money managers do not have knowledge of each other’s attitudes toward risk but can learn about them by observing their investment policies. Basak and Makarov also think it would be of interest to extend the approach they have used to investigate the possible strategic interactions among CEOs, whose contracts often include a bonus for high performance relative to their peers.
This is an executive summary of ‘Strategic asset allocation in money management’, by Suleyman Basak and Dmitry S. Makarov, Working Paper: Social Science Research Network (http://ssrn.com).