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Rev Fin 1994; 7:351-387
© 1994 the Society for Financial Studies

Article

The dynamics of portfolio management contracts

R Heinkel1,z and NM Stoughton2
1 Faculty of Commerce and Business Administration, University of British Columbia, 2053 Main Mall, Vancouver, BC, Canada V6T 1Z2
2 University of California, Irvine, Canada
z Corresponding author

Abstract

We consider the multiperiod relationship between a client and a portfolio manager and the resulting problem of motivating a manager of unknown ability to acquire valuable information. We explore the contractual form and the optimal retention policy of the client and find that the optimal initial set of contracts features a smaller performance based fee component paid to the manager than in a first-best contract, and the contract choice elicits only partial information about the manager. As a result, ex post performance measurement is critical to future recontracting. In general, managers are retained only if the returns on their portfolio exceed the benchmark by an appropriate amount.


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