Riding the Bubble with Convex Incentives

We show that benchmark-linked convex incentives can lead risk-averse money managers aware of mispricing to over-invest in overpriced securities. In the model, the managers' risk-seeking behavior varies in response to the interaction of mispricing with convexity and benchmarking concerns. Convexity effects can exacerbate the manager's over-investment in overvalued non-benchmark securities. In contrast, they potentially offset benchmarking effects studied in the literature, leading to under-investment in overpriced benchmark securities. Under correlated mispricing across assets, our model rationalizes positive positions in non-benchmark, negative-risk premium (i.e., "bubble") securities and "pairs trading" in two overvalued securities. Our findings help explain several empirical puzzles