IDEAS home Printed from https://ideas.repec.org/a/eee/dyncon/v36y2012i10p1600-1625.html
   My bibliography  Save this article

Management compensation and market timing under portfolio constraints

Author

Listed:
  • Agarwal, Vikas
  • Gómez, Juan-Pedro
  • Priestley, Richard

Abstract

This paper shows that portfolio constraints have important implications for management compensation and performance evaluation. In particular, in the presence of portfolio constraints, allowing for benchmarking can be beneficial. Benchmark design arises as an alternative effort inducement mechanism vis-a-vis relaxing portfolio constraints. Numerically, we solve jointly for the manager's linear incentive fee and the optimal benchmark. The size of the incentive fee and the risk adjustment in the benchmark composition are increasing in the investor's risk tolerance and the manager's ability to acquire and process private information.

Suggested Citation

  • 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.
    • Handle: RePEc:eee:dyncon:v:36:y:2012:i:10:p:1600-1625
    DOI: 10.1016/j.jedc.2012.05.006
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0165188912001133
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.jedc.2012.05.006?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to look for a different version below or search for a different version of it.

    Other versions of this item:

    References listed on IDEAS

    as
    1. Brennan, Michael J., 1993. "Agency and Asset Pricing," University of California at Los Angeles, Anderson Graduate School of Management qt53k014sd, Anderson Graduate School of Management, UCLA.
    2. Diane Del Guercio & Paula A. Tkac, 2000. "The determinants of the flow of funds of managed portfolios: mutual funds versus pension funds," FRB Atlanta Working Paper 2000-21, Federal Reserve Bank of Atlanta.
    3. Juan-Pedro Gomez & Fernando Zapatero, 2003. "Asset pricing implications of benchmarking: a two-factor CAPM," The European Journal of Finance, Taylor & Francis Journals, vol. 9(4), pages 343-357.
    4. Marcin Kacperczyk & Stijn Van Nieuwerburgh & Laura Veldkamp, 2009. "Rational Attention Allocation Over the Business Cycle," NBER Working Papers 15450, National Bureau of Economic Research, Inc.
    5. Bhattacharya, Sudipto & Pfleiderer, Paul, 1985. "Delegated portfolio management," Journal of Economic Theory, Elsevier, vol. 36(1), pages 1-25, June.
    6. Vikas Agarwal & Naveen D. Daniel & Narayan Y. Naik, 2009. "Role of Managerial Incentives and Discretion in Hedge Fund Performance," Journal of Finance, American Finance Association, vol. 64(5), pages 2221-2256, October.
    7. Suleyman Basak & Alex Shapiro & Lucie Teplá, 2006. "Risk Management with Benchmarking," Management Science, INFORMS, vol. 52(4), pages 542-557, April.
    8. Philip H. Dybvig & Heber K. Farnsworth & Jennifer N. Carpenter, 2010. "Portfolio Performance and Agency," Review of Financial Studies, Society for Financial Studies, vol. 23(1), pages 1-23, January.
    9. Admati, Anat R & Pfleiderer, Paul, 1997. "Does It All Add Up? Benchmarks and the Compensation of Active Portfolio Managers," The Journal of Business, University of Chicago Press, vol. 70(3), pages 323-350, July.
    10. D Blake & B N Lehmann & A Timmermann, 2002. "Performance clustering and incentives in the UK pension fund industry," Journal of Asset Management, Palgrave Macmillan, vol. 3(2), pages 173-194, September.
    11. Stijn Van Nieuwerburgh & Laura Veldkamp, 2010. "Information Acquisition and Under-Diversification," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 77(2), pages 779-805.
    12. Edwin J. Elton & Martin J. Gruber & Christopher R. Blake, 2003. "Incentive Fees and Mutual Funds," Journal of Finance, American Finance Association, vol. 58(2), pages 779-804, April.
    13. Admati, Anat R, et al, 1986. "On Timing and Selectivity," Journal of Finance, American Finance Association, vol. 41(3), pages 715-730, July.
    14. Chevalier, Judith & Ellison, Glenn, 1997. "Risk Taking by Mutual Funds as a Response to Incentives," Journal of Political Economy, University of Chicago Press, vol. 105(6), pages 1167-1200, December.
    15. Suleyman Basak & Anna Pavlova & Alexander Shapiro, 2007. "Optimal Asset Allocation and Risk Shifting in Money Management," Review of Financial Studies, Society for Financial Studies, vol. 20(5), pages 1583-1621, 2007 21.
    16. Basak, Suleyman & Pavlova, Anna & Shapiro, Alexander, 2008. "Offsetting the implicit incentives: Benefits of benchmarking in money management," Journal of Banking & Finance, Elsevier, vol. 32(9), pages 1883-1893, September.
    17. Erik R. Sirri & Peter Tufano, 1998. "Costly Search and Mutual Fund Flows," Journal of Finance, American Finance Association, vol. 53(5), pages 1589-1622, October.
    18. Juan-Pedro Gómez & Tridib Sharma, 2006. "Portfolio delegation under short-selling constraints," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 28(1), pages 173-196, May.
    19. Massimo Massa, 2009. "Incentives and Mutual Fund Performance: Higher Performance or Just Higher Risk Taking?," Review of Financial Studies, Society for Financial Studies, vol. 22(5), pages 1777-1815, May.
    20. 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.
    21. Mark Grinblatt & Sheridan Titman, 1989. "Adverse Risk Incentives and the Design of Performance-Based Contracts," Management Science, INFORMS, vol. 35(7), pages 807-822, July.
    22. Almazan, Andres & Brown, Keith C. & Carlson, Murray & Chapman, David A., 2004. "Why constrain your mutual fund manager?," Journal of Financial Economics, Elsevier, vol. 73(2), pages 289-321, August.
    23. Guercio, Diane Del & Tkac, Paula A., 2002. "The Determinants of the Flow of Funds of Managed Portfolios: Mutual Funds vs. Pension Funds," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(4), pages 523-557, December.
    24. Nagel, Stefan, 2005. "Short sales, institutional investors and the cross-section of stock returns," Journal of Financial Economics, Elsevier, vol. 78(2), pages 277-309, November.
    25. Golec, Joseph & Starks, Laura, 2004. "Performance fee contract change and mutual fund risk," Journal of Financial Economics, Elsevier, vol. 73(1), pages 93-118, July.
    26. Stoughton, Neal M, 1993. "Moral Hazard and the Portfolio Management Problem," Journal of Finance, American Finance Association, vol. 48(5), pages 2009-2028, December.
    27. Sanjiv Ranjan Das & Rangarajan K. Sundaram, 2002. "Fee Speech: Signaling, Risk-Sharing, and the Impact of Fee Structures on Investor Welfare," Review of Financial Studies, Society for Financial Studies, vol. 15(5), pages 1465-1497.
    28. Alexander, Gordon J. & Baptista, Alexandre M., 2008. "Active portfolio management with benchmarking: Adding a value-at-risk constraint," Journal of Economic Dynamics and Control, Elsevier, vol. 32(3), pages 779-820, March.
    29. Agarwal, Vikas & Daniel, Naveen D. & Naik, Narayan Y., 2009. "Role of managerial incentives and discretion in hedge fund performance," CFR Working Papers 04-04, University of Cologne, Centre for Financial Research (CFR).
    30. Suleyman Basak & Anna Pavlova, 2013. "Asset Prices and Institutional Investors," American Economic Review, American Economic Association, vol. 103(5), pages 1728-1758, August.
    31. C. Wei Li & Ashish Tiwari, 2009. "Incentive Contracts in Delegated Portfolio Management," Review of Financial Studies, Society for Financial Studies, vol. 22(11), pages 4681-4714, November.
    32. Starks, Laura T., 1987. "Performance Incentive Fees: An Agency Theoretic Approach," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 22(1), pages 17-32, March.
    33. Bruce N. Lehmann & Allan Timmermann, 2002. "(UBS Pensions Series 3) Performance Clustering and Incentives in the UK Pension Fund Industry," FMG Discussion Papers dp425, Financial Markets Group.
    34. Brown, Keith C & Harlow, W V & Starks, Laura T, 1996. "Of Tournaments and Temptations: An Analysis of Managerial Incentives in the Mutual Fund Industry," Journal of Finance, American Finance Association, vol. 51(1), pages 85-110, March.
    35. Heinkel, Robert & Stoughton, Neal M, 1994. "The Dynamics of Portfolio Management Contracts," Review of Financial Studies, Society for Financial Studies, vol. 7(2), pages 351-387.
    36. Daniel N. Deli, 2002. "Mutual Fund Advisory Contracts: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 57(1), pages 109-133, February.
    37. Hui Ou-Yang, 2003. "Optimal Contracts in a Continuous-Time Delegated Portfolio Management Problem," Review of Financial Studies, Society for Financial Studies, vol. 16(1), pages 173-208.
    38. Agarwal, Vikas & Boyson, Nicole M. & Naik, Narayan Y., 2009. "Hedge Funds for Retail Investors? An Examination of Hedged Mutual Funds," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 44(2), pages 273-305, April.
    39. Golec, Joseph H., 1992. "Empirical Tests of a Principal-Agent Model of the Investor-Investment Advisor Relationship," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 27(1), pages 81-95, March.
    40. Jeffrey L. Coles & Jose Suay & Denise Woodbury, 2000. "Fund Advisor Compensation in Closed‐End Funds," Journal of Finance, American Finance Association, vol. 55(3), pages 1385-1414, June.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. 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.
    2. 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).
    3. 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.
    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. Alexander, Gordon J. & Baptista, Alexandre M., 2010. "Active portfolio management with benchmarking: A frontier based on alpha," Journal of Banking & Finance, Elsevier, vol. 34(9), pages 2185-2197, September.
    6. Livio Stracca, 2006. "Delegated Portfolio Management: A Survey Of The Theoretical Literature," Journal of Economic Surveys, Wiley Blackwell, vol. 20(5), pages 823-848, December.
    7. Emilio Barucci & Gaetano Bua & Daniele Marazzina, 2018. "On relative performance, remuneration and risk taking of asset managers," Annals of Finance, Springer, vol. 14(4), pages 517-545, November.
    8. Basak, Suleyman & Pavlova, Anna & Shapiro, Alexander, 2008. "Offsetting the implicit incentives: Benefits of benchmarking in money management," Journal of Banking & Finance, Elsevier, vol. 32(9), pages 1883-1893, September.
    9. Servaes, Henri & Sigurdsson, Kari, 2022. "The Costs and Benefits of Performance Fees in Mutual Funds," Journal of Financial Intermediation, Elsevier, vol. 50(C).
    10. 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.
    11. Ferson, Wayne E., 2013. "Investment Performance: A Review and Synthesis," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 969-1010, Elsevier.
    12. Basak, Suleyman & Pavlova, Anna & Shapiro, Alex, 2003. "Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management," Working papers 4303-03, Massachusetts Institute of Technology (MIT), Sloan School of Management.
    13. 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.
    14. Raphaëlle Bellando, 2008. "Le conflit d'agence dans la gestion déléguée de portefeuille : une revue de littérature," Revue d'économie politique, Dalloz, vol. 118(3), pages 317-339.
    15. He, Zhiguo & Xiong, Wei, 2013. "Delegated asset management, investment mandates, and capital immobility," Journal of Financial Economics, Elsevier, vol. 107(2), pages 239-258.
    16. Suleyman Basak & Anna Pavlova & Alexander Shapiro, 2007. "Optimal Asset Allocation and Risk Shifting in Money Management," Review of Financial Studies, Society for Financial Studies, vol. 20(5), pages 1583-1621, 2007 21.
    17. Juan-Pedro Gómez & Tridib Sharma, 2006. "Portfolio delegation under short-selling constraints," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 28(1), pages 173-196, May.
    18. Alexander, Gordon J. & Baptista, Alexandre M., 2008. "Active portfolio management with benchmarking: Adding a value-at-risk constraint," Journal of Economic Dynamics and Control, Elsevier, vol. 32(3), pages 779-820, March.
    19. 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.
    20. Jakša Cvitanić & Julien Hugonnier, 2022. "Optimal fund menus," Mathematical Finance, Wiley Blackwell, vol. 32(2), pages 455-516, April.

    More about this item

    Keywords

    Market timing; Incentive fee; Benchmarking; Portfolio constraints;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:dyncon:v:36:y:2012:i:10:p:1600-1625. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/jedc .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.