Is There Too Much Benchmarking of Asset Managers ?

We ask why benchmarks are so pervasive in asset management, and what the general-equilibrium effects of using them are. In our model, asset managers’ portfolios are unobservable and the managers incur some private costs in running them. The managers are paid based on their performance. Conditioning asset managers’ compensation on performance of a benchmark portfolio partially protects them from risk, and thus gives them incentives to generate higher returns. In general equilibrium, the use of such incentive contracts creates an externality through their effect on asset prices. Benchmarking inflates asset prices and gives rise to crowded trades, thereby reducing the effectiveness of incentive contracts for others. We show that privately-optimal contracts chosen by fund investors diverge from socially-optimal ones. A social planner, recognizing the crowding, opts for less benchmarking and less incentive provision. Privately-optimal contracts end up forcing asset managers to invest too much at too high a cost, and the planner corrects this. The planner’s choice of benchmark portfolio weights also differs from the privately-optimal one. JEL Codes: D82, D86, G11, G12, G23