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 boosts their incentives to invest in risky assets. 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.
JEL Codes: D82, D86, G11, G12, G23
Keywords: Incentive Contracts, Moral Hazard, Relative Performance, Pecuniary
Externality, Asset Management, Benchmark, Index, Welfare, ESG Investing
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