We study the joint determination of fund managers' contracts and equilibrium asset prices.Because of agency frictions, investors make managers' fees more sensitive to performance and benchmark performance against a market index. This makes managers unwilling to deviate from the index and exacerbates price distortions. Because trading against overvaluation exposes managers to greater risk of deviating from the index than trading against undervaluation, agency frictions bias the aggregate market upwards. They can also generate a negative relationship between risk and return because they raise the volatility of overvalued assets. Socially optimal contracts provide steeper performance incentives and cause larger pricing distortions than privately optimal contracts. *
We study the joint determination of fund managers' contracts and equilibrium asset prices.Because of agency frictions, investors make managers' fees more sensitive to performance and benchmark performance against a market index. This makes managers unwilling to deviate from the index and exacerbates price distortions. Because trading against overvaluation exposes managers to greater risk of deviating from the index than trading against undervaluation, agency frictions bias the aggregate market upwards. They can also generate a negative relationship between risk and return because they raise the volatility of overvalued assets. Socially optimal contracts provide steeper performance incentives and cause larger pricing distortions than privately optimal contracts. *
We study the equilibrium implications of an economy in which asset managers are each subject to a different benchmark. We demonstrate how heterogeneous benchmarking endogenously generates a mechanism through which fundamental shocks propagate across assets. Despite independent asset fundamentals, heterogeneous benchmarking may give rise to negative short-run asset return correlation. We show that an asset that is included in a benchmark can not only be negatively correlated with assets included in a different benchmark, but also with assets belonging to the same benchmark. Our results are in line with the weakened comovements across investment styles and industry-sector portfolios. Moreover, the presence of institutions with different benchmarks triggers additional price pressure amplifying return volatility beyond the levels characterizing an economy in which all benchmarks are identical. Our setting is tractable and we obtain our results in closed-form.
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