New Developments in Long-Term Asset Management

Supported by the Norwegian Finance Initiative
Monika Piazzesi and Luis Viceira, Organizers
Second Annual Conference
New York, New York

May 19-20, 2017

Do Institutional Incentives Distort Asset Prices?

Anton Lines of London Business School argues that fund managers' compensation contracts, intended to align their incentives with those of their clients, may have unintended negative consequences for asset price efficiency. A sizeable fraction of delegated asset managers are paid either explicitly or implicitly according to their performance in excess of a benchmark index such as the S&P 500. By inducing fund managers to care about the tracking error of their portfolios, such contracts effectively penalize managers for deviating from the benchmark, and penalize them to a greater extent when market volatility is high. Because market volatility and portfolio tracking error volatility are closely linked, fund managers face incentives to rebalance their portfolios towards their benchmarks when volatility rises in order to control the associated rise in tracking error volatility.   [Download the paper]

Other Conference Papers

Institutional Investors and Information Acquisition, Matthijs Breugem and Adrian Buss

The Relevance of Broker Networks for Information Diffusion in the Stock Market, Marco Di Maggio, Francesco A. Franzoni, Amir Kermani, and Carlo Sommavilla

Asset Insulators, Gabriel Chodorow-Reich, Andra C. Ghent, and Valentin Haddad

Chasing Private Information, Marcin T. Kacperczyk and Emiliano Pagnotta

ETF Arbitrage under Liquidity Mismatch, Kevin Pan and Yao Zeng

Replicating Private Equity, Erik Stafford

Efficiently Inefficient Markets for Assets and Asset Management, Nicolae Gârleanu and Lasse Heje Pedersen

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Lines develops a mathematical model to illustrate this effect. He then finds support for the model's predictions using Form-13F institutional holdings data, collected from disclosures mandated by the Securities and Exchange Commission. When market volatility rises, institutional fund managers decrease their active share, a holdings-based measure of similarity to the benchmark. Rebalancing in this way only affects prices if enough fund managers hold similar positions and would therefore want to trade in the same direction. The study confirms that aggregate holdings of the entire sector often deviate from the benchmark weight, and that these aggregate deviations tend to decrease in magnitude when volatility rises.

To test whether this behaviour generates price distortions, Lines forms hypothetical portfolios of stocks sorted into quintiles by their aggregate deviation from the benchmark. In quarters when the rise in volatility is in the top quintile, aggregate-underweight portfolios outperform aggregate-overweight portfolios by 3 to 8 percent per quarter, depending on the sample, the method of risk adjustment and how the overweight/underweight quintiles are constructed. These price effects come into play precisely when market-wide uncertainty is rising and distortions are least tolerable. If firm managers use a stock's price as an input into their decision making, this may distort real investment and M&A activity.


The price effects are stronger in the second half of the sample, 1997 to 2014, consistent with the rising influence of financial institutions. Delegated asset managers accounted for 5 percent of U.S. equity holdings in 1980 and almost 30 percent in 2014. More importantly, the price effects are only observed for active institutions with clear benchmarking incentives — that is, for delegated fund managers but not for banks, insurance companies, defined-benefit pension funds, or index funds. These "placebo" tests rule out alternative explanations such as time-varying investment opportunities, which should affect all groups similarly. A final alternative explanation of the findings involves capital outflows, which may be greater in high-volatility periods. Lines finds that fund flows affect prices but that their effect is unrelated to the benchmark-rebalancing channel. The findings therefore provide support for a previously unrecognized link between institutional demand and security prices.

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