A14: Passive Investing, Intermediaries, and Asset Prices
This project is part of the research unit "Financial Markets and Frictions - An Intermediary Asset Pricing Approach" that studies the asset pricing implications of the intermediation of financial decisions. This approach is based on the observation that most households do not invest directly in asset markets. They rather delegate their investment decisions to intermediaries such as mutual funds. If these funds are actively managed, then these entities also make portfolio choices on behalf of the households and decide upon the asset mix. In this respect, intermediaries provide two kinds of services: they give households access to certain markets that might not be accessible for a direct investment and additionally make portfolio decisions for these households. The previous literature on intermediate asset pricing (IAP) is built on models where the funds are managed by active fund managers. It is assumed that the managers' contracts are monotonically increasing in the fund performance. In practice, however, there is by now a sizable number of passive funds. For instance, in 2019 passive funds account for about 45% of U.S. stock fund assets according to the financial services firm Morningstar. Passive funds do not offer the service of active portfolio management, but promise to track a certain benchmark index (e.g., DAX 30, Dow Jones, S&P 500). For such a fund, it is not plausible that a monotonic contract for the fund manager is incentive-compatible, i.e., incentivizes a manager to replicate the benchmark as close as possible. By contrast, contracts should involve non-monotonic components such as the tracking error which is the squared deviation from the index.To complement and extend the existing literature, our project recognizes the importance of passive fund management. Consequently, we focus on situations in which households engage with intermediaries to get access to involved passive investment strategies such as investing in the MSCI world index. We study the effect of the delegation of these decisions and the corresponding general-equilibrium pricing implications. Therefore, our project is at the heart of intermediary asset pricing, but in contrast to most of the literature, we focus on passive funds and also put an emphasis on optimal contracting. We believe that the question of optimal contracting is crucial for IAP models, since asset-pricing implications are biased if suboptimal and/or unrealistic contracts are exogenously imposed. We also take peer effects into account, i.e., we allow benchmarks to be endogenously determined by players within the model. Although we focus on managers of passive funds, in a later stage of the project, we might also include active fund managers to study interplay between these two fund types.
Project Leader: Prof. Dr. Holger Kraft