Decentralized Decision Making In Investment Management

Abstract

We study the investment problem of a pension fund, which employs multiple asset managers to implement investment strategies in separate asset classes. The Chief Investment Officer (CIO) of the fund allocates capital to the managers taking into account the liabilities of the fund. The managers subsequently allocate these funds to the assets in their asset class. This organizational structure relies on the premise that managers have specific stock selection skills that allow them to outperform passive benchmarks. However, by decentralizing asset allocation decisions, the fund introduces several inefficiencies due to (i) reduced opportunities to manage mismatch risk, (ii) a loss in diversification, and (iii) imperfectly observable appetites for managerial risk taking. If the CIO compensates the managers using cash benchmarks, the information ratio required for each active manager to justify this organizational structure ranges from 0.4 to 1.3. However, we derive optimal benchmarks that substantially mitigate the inefficiencies, while preserving the potential benefits of active management. The optimal performance benchmarks reflect the risk in the liabilities. We therefore develop a novel framework to implement liabilities-driven investment (LDI) strategies. * Binsbergen: jvb2@gsb.stanford.edu. Brandt: mbrandt@duke.edu. Koijen: ralph.koijen@chicagobooth.edu. We thank Keith Ambachtsheer, Rob Bauer, Lans Bovenberg, Ned Elton, Marty Gruber, Niels Kortleve, and Theo Nijman for useful discussions and suggestions. This project has been sponsored by the International Center for Pension Fund Management (ICPM) at the Rotman School.

Fund Flows Inducing Mispricing of Risk in Competitive Financial Markets

“…First, it relates to the benchmark literature, which widely accepts the concept that fund managers are generally evaluated against an exogenous benchmark (Admati and Pfleiderer, 1997;Basak, Shapiro, and Teplá, 2006). In the literature benchmarking is seen as a valuable tool to judge the performance of investment managers (Rennie and Cowhey, 1990;Binsbergen, Brandt, and Koijen, 2008) while in practice relative evaluation against a benchmark has become so common that following the benchmark is considered a riskless strategy (Brennan and Li, 2008). Basak, Pavlova, and Shapiro (2007) solve the asset managers' maximization problem when fund flows are explicitly linked to the benchmarked fund performance and find risk-shifting behavior on an individual level.…”