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

We analyze the implications of linking the compensation of fund managers to the return of their portfolio relative to that of a benchmark – a common solution to the agency problem in delegated portfolio management. In the presence of such relative-performance-based objectives, investors have reduced expected utility but markets are typically more informative and deeper, provided that information is free. Furthermore, in a multiple asset/market framework, we show that (i) relative performance concerns lead to financial contagion; (ii) benchmark inclusion increases price volatility; and (iii) home bias emerges as a rational outcome. When information is costly, however, information acquisition is hindered and this attenuates the effects on informativeness and depth of the market.