Article

Performance Based Fees, Incentives, and Dynamic Tracking Error Choice

Bernd Scherer and Xiaodong Xu

in The Oxford Handbook of Quantitative Asset Management

Published in print December 2011 | ISBN: 9780199553433
Published online November 2012 | | DOI: http://dx.doi.org/10.1093/oxfordhb/9780199553433.013.0010

Series: Oxford Handbooks in Finance

 Performance Based Fees, Incentives, and Dynamic Tracking Error Choice

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This article investigates the determination of the optimal active risk policy as a function of time and relative performance (state variables) using stochastic programming techniques. The multi-period model assumes there is a minimum performance knockout barrier for the investor, in order to consider the investor's performance tolerance in a dynamic investment environment, and he can then observe the performance of the fund dynamically. A more formal specification of the model is such that the investor turns over a sum of money to the fund manager and delegates fund investment decisions to him over a certain length of time. The relationship between active risk and active return is specified by an active efficient frontier. A multinomial scenario tree is generated to represent the possible realization of the managed portfolio's relative performance at the end of each stage, and then the backward induction method is used to find the optimal solution. The scenario-tree generated is a lattice approximation of the state space of relative returns. There are two sources of inaccuracy in using a lattice that include the quantization error and specification error. The quantization error is incurred by approximating a continuous distribution with discrete outcomes while mismatching between the barrier level and the available lattice points causing a specification error.

Keywords: dynamic programming; optimal active risk policy; stochastic programming techniques; multi-period model; quantization error; specification error

Article.  9290 words. 

Subjects: Economics ; Financial Markets ; Econometric and Statistical Methods and Methodology: General

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