PORTFOLIO PERFORMANCE AND AGENCY

Abstract

The literature traditionally assumes that a portfolio manager who expends costly effort to generate information makes an unrestricted portfolio choice and is paid according to a sharing rule. However, the revelation principle provides a more efficient institution. If credible communication of the signal is possible, then the optimal contract restricts portfolio choice and pays the manager a fraction of a benchmark plus a bonus proportional to performance relative to the benchmark. If credible communication is not possible, an additional incentive to report extreme signals may be required to remove a possible incentive to underprovide effort and feign a neutral signal.