Optimal Contracts in a Continuous-Time Delegated Portfolio Management Problem

Abstract

This article studies the contracting problem between an individual investor and a professional portfolio manager in a continuous-time principal-agent framework. Optimal contracts are obtained in closed form. These contracts are of a symmetric form and suggest that a portfolio manager should receive a fixed fee, a fraction of the total assets under management, plus a bonus or a penalty depending upon the portfolio’s excess return relative to a benchmark portfolio. The appropriate benchmark portfolio is an active index that contains risky assets where the number of shares invested in each asset can vary over time, rather than a passive index in which the number of shares invested in each asset remains constant over time. Fund managers’ compensation schemes in a delegated portfolio management setting have been of special interest to both academics and practitioners. Academic interest stems in part from the rapid growth of managed funds over the last two decades. Gompers and Metrick (1998) report that by December 1996, mutual funds, pension funds, and other financial intermediaries held discretional control over more than half of the U.S. equity market. It is thus of importance to study the impact of institutional trading on asset prices and to integrate into one model both asset pricing and delegated portfolio management compensation, as advocated by Brennan (1993), Allen and Santomero (1997), and Allen (2001). It is also important to understand the relationship between a manager’s trading strategies and his implicit incentives or career concerns [see, e.g., Brown, Harlow, and Starks (1996), Brown, Goetzmann, and Park (1997), Chevalier and Ellison (1999), and Chen and Pennacchi (2000)]. These concerns include internal promotion from a small to a large fund, higher outside offers, and the flow of money through the fund under management. 1 The importance of fund manager compensation is also underscored by Congressional passage in 1970 of the Amendment to