Working Paper: CEPR ID: DP16296
Authors: Anil K. Kashyap; Natalia Kovrijnykh; Jian Li; Anna Pavlova
Abstract: We propose a tractable model of asset management in which benchmarking arises endogenously, and analyze its unintended welfare consequences. Fund managers’ portfolios are not contractible and they incur private costs in running them. Incentive contracts for fund managers create a pecuniary externality through their effect on asset prices. Benchmarking inflates asset prices and creates crowded trades. The crowding reduces the effectiveness of benchmarking in incentive contracts for others, which fund investors fail to account for. A social planner, recognizing the crowding, opts for contracts with less benchmarking andless incentive provision. The planner also delivers lower asset management costs.
Keywords: incentive contracts; moral hazard; relative performance; pecuniary externality; asset management; benchmark index; welfare
JEL Codes: D82; D86; G11; G12; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Incentive contracts for fund managers (G23) | inflated asset prices (E31) |
| inflated asset prices (E31) | crowded trades (F19) |
| crowded trades (F19) | lower expected returns on those assets (G19) |
| crowded trades (F19) | reduced effectiveness of benchmarking in incentive contracts for other fund managers (M52) |
| social planner opts for contracts with less benchmarking and less incentive provision (D86) | lower asset management costs (G19) |
| individual fund investors underestimate the costs associated with incentive provision (G23) | inefficiency in the market (D61) |
| social planner internalizes externalities (D62) | more socially optimal allocation of resources (D61) |
| privately optimal contracts (D86) | over-incentivize risk-taking (G41) |
| over-incentivize risk-taking (G41) | higher management costs (D23) |