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Optimal benchmarking for active portfolio managers

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  • Lioui, Abraham
  • Poncet, Patrice

Abstract

Within an agency theoretic framework adapted to the portfolio delegation issue, we show how to construct optimal benchmarks. In accordance with US regulations, the benchmark-adjusted compensation scheme is taken to be symmetric. The investor’s control consists in forcing the manager to adopt the appropriate benchmark so that his first-best optimum is attained. Solving simultaneously the manager’s and the investor’s dynamic optimization programs in a fairly general framework, we characterize the optimal benchmark. We then provide completely explicit solutions when the investor’s and the manager’s utility functions exhibit different CRRA parameters. We find that, even under optimal benchmarking, it is never optimal for the manager, and therefore for the investor, to follow exactly the benchmark, except in a very restrictive case. We finally assess by simulation the practical importance, in particular in terms of the investor’s welfare, of selecting a sub-optimal benchmark.

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Bibliographic Info

Article provided by Elsevier in its journal European Journal of Operational Research.

Volume (Year): 226 (2013)
Issue (Month): 2 ()
Pages: 268-276

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Handle: RePEc:eee:ejores:v:226:y:2013:i:2:p:268-276

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Web page: http://www.elsevier.com/locate/eor

Related research

Keywords: Benchmarking; Incentive fees; Mutual funds; Continuous time trading; Martingale approach; Principal-agent model;

References

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Cited by:
  1. Marina Di Giacinto & Salvatore Federico & Fausto Gozzi & Elena Vigna, 2012. "Income drawdown option with minimum guarantee," Carlo Alberto Notebooks 272, Collegio Carlo Alberto.

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