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Portfolio Choice when Managers Control Returns

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  • Egil Matsen

    ()
    (Department of Economics, Norwegian University of Science and Technology)

Abstract

This paper investigates the allocation decision of an investor with two projects. Separate managers control the mean return from each project, and the investor may or may not observe the managers’ actions. We show that the investor’s risk-return trade-off may be radically different from a standard portfolio choice setting, even if managers’ actions are observable and enforceable. In particular, feedback effects working through optimal contracts and effort levels imply that expected terminal wealth is nonlinear in initial wealth allocation. The optimal portfolio may involve very little diversification, despite projects that are highly symmetric in the underlying model. We also show that moral hazard in one of the projects need not imply lower allocation to that project. Expected returns are generally lower than under the first-best, but the optimal contract shifts more of the idiosyncratic risk in the hidden action project to the manager in charge of it. The minimum-variance position of the investor’s (net) terminal wealth would in most cases involve a portfolio shift towards the hidden action project, and there are plausible cases where this would dominate the overall effect on the second-best optimal portfolio when comparing with the first-best.

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File URL: http://www.svt.ntnu.no/iso/WP/2006/2MHHB_feb_06.pdf
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Bibliographic Info

Paper provided by Department of Economics, Norwegian University of Science and Technology in its series Working Paper Series with number 6606.

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Length: 28 pages
Date of creation: 05 Feb 2006
Date of revision:
Handle: RePEc:nst:samfok:6606

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Keywords: Portfolio choice; diversification; optimal contracts;

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  1. Bengt Holmstrom & Paul R. Milgrom, 1985. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Cowles Foundation Discussion Papers 742, Cowles Foundation for Research in Economics, Yale University.
  2. 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.
  3. Bengt Holmstrom, 1982. "Moral Hazard in Teams," Bell Journal of Economics, The RAND Corporation, vol. 13(2), pages 324-340, Autumn.
  4. Noah Williams, 2004. "On Dynamic Principal-Agent Problems in Continuous Time," Levine's Bibliography 122247000000000426, UCLA Department of Economics.
  5. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942.
  6. 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.
  7. Karen K. Lewis, 1999. "Trying to Explain Home Bias in Equities and Consumption," Journal of Economic Literature, American Economic Association, vol. 37(2), pages 571-608, June.
  8. Jaeyoung Sung, 1995. "Linearity with Project Selection and Controllable Diffusion Rate in Continuous-Time Principal-Agent Problems," RAND Journal of Economics, The RAND Corporation, vol. 26(4), pages 720-743, Winter.
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