Benchmarking Asset Managers

This project analyzes the role of asset managers on asset prices and social welfare. Asset management is a large and growing industry, central to the allocation of financial assets on behalf of investors. There is an ongoing debate over whether the actions of large asset managers might be contributing to systemic risk, and if so whether they ought to be regulated. Our goal is to shed light on this issue through the lens of a theoretical model, where asset managers’ contracts and equilibrium asset prices are jointly determined. We build a dynamic asset-pricing model, in which investors use asset managers for managing their investment portfolios. In practice, asset managers’ performance is evaluated relative to a benchmark (for instance, a market index such as S&P 500), which determines the managers’ compensation. In the model, benchmarking occurs as a result of agency frictions (moral hazard): investors optimally choose managers’ fees to be contingent on their performance relative to that of a benchmark index. Benchmarking makes asset managers invest more in the index than they would have otherwise. We show that this in turn increases the price of assets in the index, and makes the asset returns more volatile and more correlated. Because investors do not account for these effects of their contracts on equilibrium asset prices, privately-optimal contracts involve an externality. We want to explore how the contract chosen by the social planner differs from the privately-optimal one. We also plan to analyze the equilibrium effects of an expansion of the asset management sector.