Delegated Portfolio Management, Benchmarking, and the Effects on Financial Markets

We analyze the implications of linking the compensation of fund managers to the returnof their portfolio relative to that of a benchmark—a common solution to the agencyproblem in delegated portfolio management. In the presence of such relativeperformance-based objectives, investors have reduced expected utility but markets aretypically more informative and deeper. Furthermore, in a multiple asset/marketframework we show that (i) relative performance concerns lead to an increase in thecorrelation between markets (financial contagion); (ii) benchmark inclusion increasesprice volatility; (iii) home bias emerges as a rational outcome. When information iscostly, information acquisition is hindered and this attenuates the effects oninformativeness and depth of the market.