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Optimal Decentralized Investment Management

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  • JULES H. van BINSBERGEN
  • MICHAEL W. BRANDT
  • RALPH S. J. KOIJEN

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. Copyright (c) 2008 The American Finance Association.

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Bibliographic Info

Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 63 (2008)
Issue (Month): 4 (08)
Pages: 1849-1895

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Handle: RePEc:bla:jfinan:v:63:y:2008:i:4:p:1849-1895

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Citations

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Cited by:
  1. Lim, Andrew E.B. & Wong, Bernard, 2010. "A benchmarking approach to optimal asset allocation for insurers and pension funds," Insurance: Mathematics and Economics, Elsevier, vol. 46(2), pages 317-327, April.
  2. de Groot, W. & Pang, J. & Swinkels, L.A.P., 2012. "The Cross-Section of Stock Returns in Frontier Emerging Markets," ERIM Report Series Research in Management ERS-2012-012-F&A, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus Uni.
  3. Alexander, Gordon J. & Baptista, Alexandre M., 2011. "Portfolio selection with mental accounts and delegation," Journal of Banking & Finance, Elsevier, vol. 35(10), pages 2637-2656, October.
  4. Vasconcelos, Luis & Mukherjee, Arijit, 2010. "Optimal Job Design In The Presence Of Implicit Contracts," FEUNL Working Paper Series wp551, Universidade Nova de Lisboa, Faculdade de Economia.
  5. Agarwal, Vikas & Nada, Vikram & Ray, Sugata, 2013. "Institutional investment and intermediation in the hedge fund industry," CFR Working Papers 13-03, University of Cologne, Centre for Financial Research (CFR).
  6. Jules H. van Binsbergen & Michael W. Brandt, 2007. "Optimal Asset Allocation in Asset Liability Management," NBER Working Papers 12970, National Bureau of Economic Research, Inc.
  7. Zhiguo He & Wei Xiong, 2008. "Delegated Asset Management, Investment Mandates, and Capital Immobility," NBER Working Papers 14574, National Bureau of Economic Research, Inc.
  8. Basak, Suleyman & Makarov, Dmitry, 2011. "Strategic Asset Allocation in Money Management," CEPR Discussion Papers 8457, C.E.P.R. Discussion Papers.
  9. Alexander, Gordon J. & Baptista, Alexandre M., 2010. "Active portfolio management with benchmarking: A frontier based on alpha," Journal of Banking & Finance, Elsevier, vol. 34(9), pages 2185-2197, September.
  10. Dass, Nishant & Nanda, Vikram & Wang, Qinghai, 2013. "Allocation of decision rights and the investment strategy of mutual funds," Journal of Financial Economics, Elsevier, vol. 110(1), pages 254-277.
  11. Sheng, Jiliang & Wang, Jian & Wang, Xiaoting & Yang, Jun, 2014. "Asymmetric contracts, cash flows and risk taking of mutual funds," Economic Modelling, Elsevier, vol. 38(C), pages 435-442.

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