Working Paper: NBER ID: w12144
Authors: Jules H. Van Binsbergen; Michael W. Brandt; Ralph S.J. Koijen
Abstract: We study a decentralized investment problem in which a CIO 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\nand can lead to large utility costs on the part of the CIO. We focus on i) loss of diversification ii) different appetites for risk, iii) different investment horizons, and iv) the presence of liabilities. We derive an optimal unconditional linear performance benchmark and show that this benchmark can be used to better align incentives within the firm. The optimal benchmark substantially mitigates the utility costs of decentralized investment management. These costs can be further reduced when the CIO can screen asset managers on the basis of their risk appetites. Each manager's optimal level of risk aversion depends on the asset class he manages and can differ substantially from the CIO's level of risk aversion.
Keywords: Decentralized Investment Management; Performance Benchmarks; Utility Costs; Asset Allocation; Risk Preferences
JEL Codes: G10; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Decentralized investment management (G11) | large utility costs for the CIO (L97) |
| Two-stage investment process (G31) | misalignments in objectives (L21) |
| misalignments in objectives (L21) | large utility costs for the CIO (L97) |
| Loss of diversification (G19) | suboptimal portfolio choices (G11) |
| Differing appetites for risk (D81) | large utility costs for the CIO (L97) |
| Variations in investment horizons (G11) | large utility costs for the CIO (L97) |
| Presence of liabilities (G32) | large utility costs for the CIO (L97) |
| Optimally designed performance benchmark (C52) | mitigate utility costs (L97) |
| Optimal selection of asset managers based on risk appetites (G11) | reduce utility costs (L97) |