Optimal Decentralized Investment Management
68 Pages Posted: 2 Mar 2006
Date Written: October 19, 2006
We study an institutional investment problem in which a centralized decision maker, the Chief Investment Officer (CIO), for example, 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 managers and can lead to large utility costs on the part of the CIO. We focus on (i) loss of diversification, (ii) unobservable appetites for risk of the managers, and (iii) different investment horizons. We derive an optimal unconditional linear performance benchmark and show that this benchmark can be used to better align incentives within the firm. We find that the CIO's uncertainty about the managers' risk appetites increases both the costs of decentralized investment management and the value of an optimally designed benchmark.
Keywords: Decentralized investment management, performance benchmark
JEL Classification: G0, G11, G23, G24
Suggested Citation: Suggested Citation