Contracting in Delegated Portfolio Management: The Case of Alternative Assets

This study explores the implications of portfolio opacity for the design of asset management contracts. This is a case of particular interest given the growing importance of ‘alternative’ assets like hedge funds and private equity funds in institutional portfolios. The alternative assets are often characterized by relatively illiquid or non-publicly traded holdings, proprietary strategies, and exemption from mandatory reporting requirements. These features contribute to the relative opacity or lack of transparency of the underlying portfolios. We analyze the link between portfolio opacity and the optimal portfolio management contract in this context and demonstrate that the second-best optimal contract features a convex component. The importance of the convex component is an increasing function of the portfolio’s opacity. Furthermore, the principal’s utility loss from restricting the weight of the convex component to zero is increasing in the portfolio’s opacity.