Optimal Decentralized Investment Management

Abstract

We study an institutional investment problem in which a centralized decision maker, the Chief Investment Officer (CIO), for example, employs multiple asset managers to implement 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 and can lead to large utility costs for the CIO. We focus on (1) loss of diversification, (2) unobservable managerial appetite for risk, and (3) different investment horizons. We derive an optimal unconditional linear performance benchmark and show that this benchmark can be used to better align incentives within the firm. We find that the CIO's uncertainty about the managers' risk appetites increases both the costs of decentralized investment management and the value of an optimally designed benchmark. Disciplines Finance | Finance and Financial Management CommentsAt the time of publication, author Jules van Binsbergen was affiliated with Stanford University. Currently, he is a faculty member at the Wharton School at the University of Pennsylvania. ABSTRACTWe 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 and 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.

Decentralized Investment Management: Evidence from the Pension Fund Industry

“…Specifically, the pre-fee performance of balanced managers is less than that of specialist managers, which is consistent with the higher management fees charged by specialists. 4 Further, the performance of specialists persists, particularly in the case of UK equities, the most significant asset class held by UK pension funds over our sample period. 5 Second, we examine the dynamics of the switch from balanced to specialist managers.…”

“…4 Further, the performance of specialists persists, particularly in the case of UK equities, the most significant asset class held by UK pension funds over our sample period. 5 Second, we examine the dynamics of the switch from balanced to specialist managers.…”

“…For example, pension funds can diversify (across managers) the strategies used to generate alpha to exploit the skills of specialist active managers with superior knowledge of a particular asset class (Sharpe, 1981;van Binsbergen et al, 2009). They might also employ multiple managers to induce yardstick competition and benefit from the resulting higher effort levels exerted by these managers (Shleifer, 1985).…”

“…As such, besides studying the decentralization issues highlighted by van Binsbergen et al (2008), we also study the rationality of the decentralization decision itself. 4 Our dataset does not contain information on the fees charged by the individual fund managers, although we know from industry surveys that the fees of specialists are higher than those of balanced managers, so we may infer that specialists capture at least some of the rents from their superior skill or greater effort. This result is consistent with the predictions of Berk and Green (2004).…”

Decentralized Decision Making In Investment Management

“…We follow Binsbergen et al (2008) and consider the case with two asset classes, equities and fixed income, and three assets per class. The estimates for the return dynamics are displayed in Table 1.…”