Is There Too Much Benchmarking in Asset Management?

62 Pages Posted: 28 Apr 2020 Last revised: 20 Jul 2021

See all articles by Anil K. Kashyap

Anil K. Kashyap

University of Chicago, Booth School of Business; National Bureau of Economic Research (NBER); Federal Reserve Bank of Chicago

Natalia Kovrijnykh

Arizona State University (ASU) - Economics Department

Jian Li

Columbia University

Anna Pavlova

London Business School; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: April 2, 2021

Abstract

We propose a model of asset management in which benchmarking arises endogenously, and analyze its unintended welfare consequences. Fund managers' portfolios are unobservable and they incur private costs in running them. Conditioning managers' compensation on a benchmark portfolio's performance partially protects them from risk, and thus gives them incentives to generate higher abnormal returns. In general equilibrium, these compensation contracts create an externality through their effect on asset prices. Benchmarking inflates asset prices and gives rise to crowded trades, thereby reducing the effectiveness of incentive contracts for others. Contracts chosen by fund investors diverge from socially optimal ones. A social planner, recognizing the crowding, opts for less benchmarking and less incentive provision. We also show that asset management costs are lower with socially optimal contracts, and the planner's benchmark-portfolio weights differ from the privately optimal ones. Finally, we consider an application of our model to ESG (environmental, social, and governance) investing and show that optimal incentive provision for fund managers should include ESG-tilted benchmarks.

Keywords: Incentive Contracts, Moral Hazard, Relative Performance, Externality, Asset Management, Benchmark, Index, Welfare, ESG Investing

JEL Classification: D82, D86, G11, G12, G23

Suggested Citation

Kashyap, Anil K. and Kovrijnykh, Natalia and Li, Jian and Pavlova, Anna, Is There Too Much Benchmarking in Asset Management? (April 2, 2021). Available at SSRN: https://ssrn.com/abstract=3567667 or http://dx.doi.org/10.2139/ssrn.3567667

Anil K. Kashyap

University of Chicago, Booth School of Business ( email )

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Natalia Kovrijnykh

Arizona State University (ASU) - Economics Department ( email )

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HOME PAGE: http://www.public.asu.edu/~nkovrijn

Jian Li

Columbia University ( email )

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10025 (Fax)

Anna Pavlova (Contact Author)

London Business School ( email )

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+44 20 7000 8218 (Phone)

HOME PAGE: http://faculty.london.edu/apavlova

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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