Incentive Contracts in Delegated Portfolio Management
41 Pages Posted: 22 Mar 2007 Last revised: 3 Mar 2009
Date Written: May 1, 2008
This paper analyzes optimal non-linear portfolio management contracts. We consider a setting where the investor faces moral hazard with respect to the effort and risk choices of the portfolio manager. The manager's employment contract promises her: (a) a fixed payment, (b) a proportional asset-based fee, (c) a benchmark-linked fulcrum fee, and (d) a benchmark-linked option-type bonus incentive fee. We show that the option-type incentive helps overcome the effort-underinvestment problem that undermines linear contracts. More generally, we find that for the set of contracts we consider, with the appropriate choice of benchmark it is always optimal to include a bonus incentive fee in the contract. We derive the conditions that such a benchmark must satisfy. Our results suggest that current regulatory restrictions on asymmetric performance-based fees in mutual fund advisory contracts may be costly.
Keywords: Incentive Contracts, Delegated Portfolio Management, Mutual Funds, Performance Fees
JEL Classification: G10, G20
Suggested Citation: Suggested Citation