Management Compensation and Portfolio Choice under Leverage Constraints

We analyze the implications of short-selling and margin purchase constraints for management compensation and portfolio optimization under moral hazard. First, looking at the manager’s problem, we show that her active portfolio (that is, net of the benchmark) will not be independent of the benchmark design. We solve analytically for the benchmark composition that maximizes e¤ort expenditure. Analyzing the principal’s optimal contract, we show that, under portfolio constraints, relative performance evaluation may be optimal. Numerically, we solve jointly for the manager’s incentive fee and the optimal benchmark. There exists a tradeo¤ between adverse risk-incentives (as pointed out in Roll (1992)) and sharpening the manager’s incentives in the search for more accurate (hence, pro…table) information. When the benchmark composition is endogenoulsy determined, the principal’s optimal benchmark choice will not necessarily coincide with the benchmark that maximizes the fund’s Information Ratio (excess return per unit of tracking error volatility). Deviations from the optimal contract are shown to be quantitatively onerous for the principal’s welfare, depending among other parameters, on both the principal and the manager’s risk aversion. Finally, the model yields a set of novel testable implications for mutual fund performance under portfolio constraints. Keywords: Market Timing, Incentive Fee, Benchmarking, Portfolio Constraints JEL Classi…cation Numbers: D81, D82, J33.