Evaluation Period and Agency Problem in Outsourced Chief Investment Officer (OCIO)

Abstract

This article investigates the effect of the performance evaluation period on the long-term investment portfolio choice and the agency problem of outsourced investments. Though investors with the prospect utility are required to raise the portfolio weight on risky assets such as stocks for a long investment horizon, institutional investors and professional fund managers cannot help lowering the portfolio weight on risky assets to minimize the loss and to avoid disappointing clients with a short evaluation period. We find empirical evidence in the Korean capital market that stocks and bonds are indifferent to investors with the prospect utility for an evaluation period with 16 months and the optimal portfolio weight of stocks and bonds is 30% to 70%. Therefore there exists the agency problem between investors (principal) and managers (agent) due to frequent performance evaluations, which is able to explain current excessive investment in fixed income markets of most national pension funds. Our result implies that we need to consider extending the evaluation period of the investment performance to achieve the goal of asset and liability management (ALM) of national long-term funds in this low-interest-rate environment.