Performance-Based Fees and Asset Allocation Under Loss-Aversion

This paper takes into account the most prevalent practices in terms of fees in order to study the dynamic asset allocation of fund managers exhibiting a loss aversion utility function. Managers are compensated with performance-based (asymmetric and symmetric) fees comprising an underperformance penalty component. The benchmark portfolio relative to which performance of funds is measured may be riskless or risky. Whatever the benchmark, a penalty component may lead managers to take more risk in unfavorable states of the world and less risk in favorable states. In the case of a risky benchmark, a manager also has a position in the benchmark, which is less risky when (s)he faces a penalty