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Money managers are rewarded for increasing the value of assets under management, and predom- inately so in the mutual fund industry. This compensation scheme gives the manager an implicit incentive to exploit the well-documented positive fund-flows to relative-performance relationship by manipulating her risk exposure. It also provides her with an explicit incentive to manage the fund in accordance with her own appetite for risk. In a dynamic asset allocation framework, we show that as the year-end approaches, the interplay of these incentives induces the manager to optimally closely mimic the index, relative to which her performance is evaluated, when the fund’s year-to- date return is just sucient,to cause a higher expected flow. As she falls behind, she gradually increases her risk exposure (via leverage or short selling), reaching an extremum at a critical level of

Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management