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Incentive Contracts in Delegated Portfolio Management

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  • C. Wei Li
  • Ashish Tiwari

Abstract

This article analyzes optimal nonlinear portfolio management contracts. We consider a setting in which the investor faces moral hazard with respect to the effort and risk choices of the portfolio manager. The employment contract promises the manager: (i) a fixed payment, (ii) a proportional asset-based fee, (iii) a benchmark-linked fulcrum fee, and (iv) a benchmark-linked option-type "bonus" incentive fee. We show that the option-type incentive helps overcome the effort-underinvestment problem that undermines linear contracts. More generally, we find that for the set of contracts we consider, with the appropriate choice of benchmark it is always optimal to include a bonus incentive fee in the contract. We derive the conditions that such a benchmark must satisfy. Our results suggest that current regulatory restrictions on asymmetric performance-based fees in mutual fund advisory contracts may be costly. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

Suggested Citation

  • C. Wei Li & Ashish Tiwari, 2009. "Incentive Contracts in Delegated Portfolio Management," The Review of Financial Studies, Society for Financial Studies, vol. 22(11), pages 4681-4714, November.
    • Handle: RePEc:oup:rfinst:v:22:y:2009:i:11:p:4681-4714
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    Cited by:

    1. Haoyue Zhang & Dayong Lv & Wenfeng Wu, 2022. "Why do bank‐affiliated mutual funds perform better in China?," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 62(5), pages 4755-4782, December.
    2. Andrea M. Buffa & Dimitri Vayanos & Paul Woolley, 2022. "Asset Management Contracts and Equilibrium Prices," Journal of Political Economy, University of Chicago Press, vol. 130(12), pages 3146-3201.
    3. Zhaolin Li & Samuel N. Kirshner, 2021. "Salesforce Compensation and Two‐Sided Ambiguity: Robust Moral Hazard with Moment Information," Production and Operations Management, Production and Operations Management Society, vol. 30(9), pages 2944-2961, September.
    4. Markus Ibert & Ron Kaniel & Stijn Van Nieuwerburgh & Roine Vestman, 2018. "Are Mutual Fund Managers Paid for Investment Skill?," The Review of Financial Studies, Society for Financial Studies, vol. 31(2), pages 715-772.
    5. Sheng, Jiliang & Wang, Jian & Wang, Xiaoting & Yang, Jun, 2014. "Asymmetric contracts, cash flows and risk taking of mutual funds," Economic Modelling, Elsevier, vol. 38(C), pages 435-442.
    6. Ana C. Díaz†Mendoza & Germán López†Espinosa & Miguel A. Martínez, 2014. "The Efficiency of Performance†Based Fee Funds," European Financial Management, European Financial Management Association, vol. 20(4), pages 825-855, September.
    7. Agarwal, Vikas & Gómez, Juan-Pedro & Priestley, Richard, 2012. "Management compensation and market timing under portfolio constraints," Journal of Economic Dynamics and Control, Elsevier, vol. 36(10), pages 1600-1625.
    8. Goncalves-Pinto, Luis & Sotes-Paladino, Juan & Xu, Jing, 2018. "The invisible hand of internal markets in mutual fund families," Journal of Banking & Finance, Elsevier, vol. 89(C), pages 105-124.
    9. Cuoco, Domenico & Kaniel, Ron, 2011. "Equilibrium prices in the presence of delegated portfolio management," Journal of Financial Economics, Elsevier, vol. 101(2), pages 264-296, August.
    10. Yafeh, Yishay & Kandel, Eugene & Hamdani, Assaf & Mugerman, Yevgeny, 2015. "Incentive Fees and Competition in Pension Funds: Evidence from a Regulatory Experiment in Israel," CEPR Discussion Papers 10911, C.E.P.R. Discussion Papers.
    11. Sotes-Paladino, Juan & Zapatero, Fernando, 2022. "Carrot and stick: A role for benchmark-adjusted compensation in active fund management," Journal of Financial Intermediation, Elsevier, vol. 52(C).
    12. Xiangyu Cui & Jianjun Gao & Yun Shi, 2021. "Multi-period mean–variance portfolio optimization with management fees," Operational Research, Springer, vol. 21(2), pages 1333-1354, June.
    13. Guo, Rui & Jiang, Ying & Li, Ao & Qiu, Zhigang & Wang, Hefei, 2021. "A model of delegation with a VaR constraint," Finance Research Letters, Elsevier, vol. 42(C).
    14. Hamdani, Assaf & Kandel, Eugene & Mugerman, Yevgeny & Yafeh, Yishay, 2017. "Incentive Fees and Competition in Pension Funds: Evidence from a Regulatory Experiment," Journal of Law, Finance, and Accounting, now publishers, vol. 2(1), pages 49-86, June.
    15. Jeremy Burke & Angela A. Hung & Jack Clift & Steven Garber & Joanne K. Yoong, 2015. "Impacts of Conflicts of Interest in the Financial Services Industry," Working Papers WR-1076, RAND Corporation.
    16. Sheng, Jiliang & Wang, Xiaoting & Yang, Jun, 2012. "Incentive contracts in delegated portfolio management under VaR constraint," Economic Modelling, Elsevier, vol. 29(5), pages 1679-1685.
    17. Teresa Corzo Santamaría & Carlos Martinez de Ibarreta & Juan Rodriguez Calvo, 2018. "Timid performance fees in mutual funds," Journal of Asset Management, Palgrave Macmillan, vol. 19(1), pages 64-77, January.
    18. Wang, Jian & Sheng, Jiliang & Yang, Jun, 2013. "Optimism bias and incentive contracts in portfolio delegation," Economic Modelling, Elsevier, vol. 33(C), pages 493-499.
    19. Juan Sotes-Paladino & Fernando Zapatero, 2022. "Carrot and Stick: A Role for Benchmark-Adjusted Compensation in Active Fund Management," Working Papers 133, Red Nacional de Investigadores en Economía (RedNIE).
    20. Moreno, David & Rodríguez, Rosa & Zambrana, Rafael, 2018. "Management sub-advising in the mutual fund industry," Journal of Financial Economics, Elsevier, vol. 127(3), pages 567-587.
    21. Natasa Bilkic & Thomas Gries, 2014. "Destructive Agents, Finance Firms, and Systemic Risk," Working Papers CIE 76, Paderborn University, CIE Center for International Economics.
    22. Han, Min-Yeon & Jun, Sang-Gyung & Oh, Ji Yeol Jimmy & Kang, Hyoung-Goo, 2023. "Who should choose the money managers? Institutional sponsors' equity manager performance," Pacific-Basin Finance Journal, Elsevier, vol. 78(C).
    23. Michael Sockin & Mindy Z Xiaolan, 2023. "Delegated Learning and Contract Commonality in Asset Management," Review of Finance, European Finance Association, vol. 27(6), pages 1931-1975.

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