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RFS Advance Access published online on September 10, 2009
Review of Financial Studies, doi:10.1093/rfs/hhp056
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© The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org

Portfolio Performance and Agency

Philip H. Dybvig
Washington University in Saint Louis

Heber K. Farnsworth
Washington University in Saint Louis

Jennifer N. Carpenter
New York University

Send correspondence to Heber K. Farnsworth, Olin Business School, Washington University in Saint Louis, 1 Brookings Dr, St. Louis, MO 63130; telephone: (314) 935-6394; fax: 314-935-6359. E-mail: Farnsworth{at}olin.wustl.edu.

JEL Classification: D82, G11


  Abstract

In this paper we analyze the optimal contract for a portfolio manager who can exert effort to improve the quality of a private signal about future market prices. We assume complete markets over states distinguished by asset payoffs and place no restrictions on the form of the contract. We show that trading restrictions are essential because they prevent the manager from undoing the incentive effects of performance-based fees. We provide conditions under which simple benchmarking emerges as optimal compensation. Additional incentives to take risk are necessary when information can be manipulated or else the manager will understate information to offset the benchmarking.

We are grateful for helpful discussions with Michael Brennan, Diego Garcia, Mark Loewenstein, Bill Marshall, Chester Spatt, Neal Stoughton, Jayeoung Sung, Jaime Zender, and numerous seminar participants. We are also grateful for support from SWUFE and CKGSB.


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