Is There Too Much Benchmarking in Asset Management?

We propose a model of asset management in which benchmarking arises endogenously, and analyze its unintended welfare consequences. Fund managers' portfolios are unobservable and they incur private costs in running them. Conditioning managers' compensation on a benchmark portfolio's performance partially protects them from risk, and thus gives them incentives to generate higher abnormal returns. In general equilibrium, these compensation contracts create 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. Contracts chosen by fund investors diverge from socially optimal ones. A social planner, recognizing the crowding, opts for less benchmarking and less incentive provision. We also show that asset management costs are lower with socially optimal contracts, and the planner's benchmark-portfolio weights differ from the privately optimal ones