Optimal Contracts for Teams of Money Managers

Abstract

The optimal organizational form and optimal incentive contract are characterized for a team of money managers, assuming that the investor (principal) is risk averse and that each manager's (agent's) actions affect both that manager's expected return and the correlation of returns between managers. If the managers are risk tolerant, then a noncooperative team organization and a contract in which each manager is rewarded both for doing well and for doing better than the team, is the most efficient way to encourage managers to exert effort in diversified activities. This is despite the fact that, in such a contract total wages paid are a concave function of total returns, and so using the contract to encourage diversification (and thus achieve lower risk) is in direct conflict with the investor's objective of using the contract to transfer risk onto the managers. As the risk aversion of both the investor and the managers increases, cooperation among managers becomes the optimal way to organize the team. For some parameter values, if everyone is risk averse, a benchmark outcome (the same as first best, but with limited liability) can be achieved. The benchmark outcome with diversification of efforts can never be achieved if the managers are risk tolerant, or if cooperation is infeasible.