Working Paper: CEPR ID: DP8578
Authors: Ron Kaniel; Peter Kondor
Abstract: We analyze the effects of the observed increased share of delegated capital for trading strategies and equilibrium prices by introducing delegation into a standard Lucas exchange economy. In equilibrium, some investors trade on their own account, but others decide to delegate trading to professional fund managers. Flow performance incentive functions describe how much capital clients provide to funds at each date as a function of past performance. Convex flow-performance relations imply that the average fund outperforms the market in recessions and underperforms in expansions. When the share of capital that is delegated is low, all funds follow the same strategy. However, when the equilibrium share of delegated capital is high, funds with identical incentives employ heterogeneous trading strategies. A group of managers borrows to take on a levered position on the stock. Thus, fund returns are dispersed in the cross-section and the outstanding amounts of borrowing and lending increase. The relation between the share of delegated capital and the Sharpe ratio typically follows an inverse U-shape pattern.
Keywords: Agency; Delegation; Equilibrium; Funds; Money Management
JEL Codes: G11; G12; G19; G29
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| share of delegated capital (D33) | heterogeneous trading strategies (F12) |
| heterogeneous trading strategies (F12) | increased borrowing and lending activities (F65) |
| share of delegated capital (D33) | non-monotonic relationship with Sharpe ratio (C46) |
| share of delegated capital (D33) | increased risk-taking among managers (G34) |
| increased risk-taking among managers (G34) | larger cross-sectional dispersion in fund returns during recessions (E32) |
| share of delegated capital (D33) | underperformance in expansions (E32) |
| share of delegated capital (D33) | outperformance in recessions (E32) |