The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
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 relativeperformance-
based objectives, investors have reduced expected utility but markets are
typically more informative and deeper. Furthermore, in a multiple asset/market
framework we show that (i) relative performance concerns lead to an increase in the
correlation between markets (financial contagion); (ii) benchmark inclusion increases
price volatility; (iii) home bias emerges as a rational outcome. When information is
costly, information acquisition is hindered and this attenuates the effects on
informativeness and depth of the market.