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Jules H. van Binsbergen, Michael W. Brandt, Ralph S.J. Koijen
NBER Working Paper No. 12144
Issued in April 2006
NBER Program(s): AP
---- 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
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.
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