A Delegated Agent Asset-Pricing Model

Abstract

Asset pricing theory has traditionally made predictions about risk and return but has been silent on the actual process of investment. Many, if not most investors, delegate major investment decisions to professionals, to investment managers and financial advisors. This suggests that the instructions given by investors to their delegated agents and the compensation of those agents might be important determinants of capital market equilibrium. In the extreme when all investment decisions are delegated, the preferences and beliefs of individuals would be completely superseded by the objective functions of agent/managers. Agency theory holds that such objective functions cannot be isomorphic to principals' preferences and beliefs, which suggests that asset pricing could differ fundamentally from that predicted by existing theory. A provocative illustration of the difference is provided in this paper based on active asset management relative to a benchmark index, a common objective function in practice but with no grounding in traditional theory. With the growing preponderance of delegated investing, future asset pricing theory will not only have to describe risk and return but, to be complete, must also be able to explain the observed objective functions used by professional managers.

Keywords: Asset pricing

JEL Classification: G12