Optimal Decentralized Investment Management
Michael W. Brandt
Duke University - Fuqua School of Business; National Bureau of Economic Research (NBER)
Jules H. Van Binsbergen
University of Pennsylvania - The Wharton School; National Bureau of Economic Research (NBER)
Ralph S. J. Koijen
London Business School - Department of Finance; National Bureau of Economic Research (NBER)
NBER Working Paper No. w12144
We study a decentralized investment problem in which a CIO employs multiple asset managers to implement and execute investment strategies in separate asset classes. The CIO allocates capital to the managers who, in turn, allocate these funds to the assets in their asset class. This two-step investment process causes several misalignments of objectives between the CIO and his managersand can lead to large utility costs on the part of the CIO. We focus on i) loss of diversification ii) different appetites for risk, iii) different investment horizons, and iv) the presence of liabilities. We derive an optimal unconditional linear performance benchmark and show that this benchmark can be used to better align incentives within the firm. The optimal benchmark substantially mitigates the utility costs of decentralized investment management. These costs can be further reduced when the CIO can screen asset managers on the basis of their risk appetites. Each manager%u2019s optimal level of risk aversion depends on the asset class he manages and can differ substantially from the CIO%u2019s level of risk aversion.
Number of Pages in PDF File: 61
Date posted: May 18, 2006
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