Working Paper: CEPR ID: DP10152
Authors: Andrea M. Buffa; Dimitri Vayanos; Paul Woolley
Abstract: We study the joint determination of fund managers' contracts and equilibrium asset prices. Because of agency frictions, investors make managers' fees more sensitive to performance and benchmark performance against a market index. This makes managers unwilling to deviate from the index and exacerbates price distortions. Because trading against overvaluation exposes managers to greater risk of deviating from the index than trading against undervaluation, agency frictions bias the aggregate market upwards. They can also generate a negative relationship between risk and return because they raise the volatility of overvalued assets. Socially optimal contracts provide steeper performance incentives and cause larger pricing distortions than privately optimal contracts.
Keywords: asset pricing; delegated portfolio management; market anomalies; optimal contracts
JEL Codes: D86; G12; G14; G18; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| agency frictions (D82) | managers' fees sensitivity to performance (M52) |
| managers' fees sensitivity to performance (M52) | upward bias in aggregate market (E10) |
| agency frictions (D82) | price distortions (L11) |
| agency frictions (D82) | negative relationship between risk and expected return (D81) |
| increased volatility of overvalued assets (G19) | negative risk-return relationship (G40) |
| socially optimal contracts (D86) | steeper performance incentives (M52) |
| steeper performance incentives (M52) | larger pricing distortions (D49) |
| agency frictions (D82) | overvalued assets becoming more expensive (G19) |
| agency frictions (D82) | undervalued assets becoming cheaper (G19) |