A Model of Asset Pricing and Portfolio Delegation

Abstract

Previous analysis of equilibrium asset prices often ignore the effects of delegated portfolio management and those of delegated portfolio management problems often ignore information and equilibrium asset prices. This paper develops a dynamic model that simultaneously considers optimal contracting and equilibrium asset prices under differential information. We consider a case in which investors can contract on various signals as well as a case in which investors constrain the contract form to be of a linear function of the terminal value of their portfolios. Optimal contracts and equilibrium asset prices are characterized in both cases. We examine the impact of portfolio delegation and risk sharing on portfolio managers' trading behavior, the autocorrelation in stock returns, and the persistence of fund performance. We find that due to the less optimal risk sharing contract, the risk premium on the stock as well as the autocorrelations in both stock and fund returns are substantially higher in case 1 than in case 2. In particular, we find that under certain conditions, the autocorrelations in fund returns are positive, suggesting the persistence of fund performance. The presence of differential information among funds reduces autocorrelations in stock and fund returns, but the costs associated with managing the portfolio enhance them.