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Relative Performance Evaluation Contracts and Asset Market Equilibrium

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Author Info
Sandeep Kapur (Birkbeck College, London)
Allan Timmermann (UCSD)

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Abstract

We analyse the equilibrium consequences of performance-based contracts for fund managers. Managerial remuneration is tied to a fund's absolute performance and its performance relative to rival funds. Investors choose whether or not to delegate their investment to better-informed fund managers; if they delegate they choose the parameters of the optimal contract subject to the fund manager's participation constraint. We find that the impact of relative performance evaluation on equilibrium equity premium and on portfolio herding critically depends on whether the participation constraint is binding. Simple numerical examples suggest that the increased importance of delegation and performance evaluation may lower the equity premium.

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Paper provided by EconWPA in its series Finance with number 0408005.

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Length: 31 pages
Date of creation: 11 Aug 2004
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Handle: RePEc:wpa:wuwpfi:0408005

Note: Type of Document - pdf; pages: 31
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Web page: http://129.3.20.41

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Keywords: portfolio delegation relative performance evaluation equity premium

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G - Financial Economics

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  1. S. Bhattacharya, 1999. "Delegated portfolio management, no churning, and relative performance-based incentive/sorting schemes," THEMA Working Papers 99-22, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise.
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  2. Palomino, Frederic & Prat, Andrea, 2003. " Risk Taking and Optimal Contracts for Money Managers," RAND Journal of Economics, The RAND Corporation, vol. 34(1), pages 113-37, Spring.
  3. Eugene F. Fama & Kenneth R. French, 2002. "The Equity Premium," Journal of Finance, American Finance Association, vol. 57(2), pages 637-659, 04. [Downloadable!] (restricted)
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  4. Bhattacharya, Sudipto & Pfleiderer, Paul, 1985. "Delegated portfolio management," Journal of Economic Theory, Elsevier, vol. 36(1), pages 1-25, June. [Downloadable!] (restricted)
  5. Matthew I. Spiegel & Harry Mamaysky, 2001. "A Theory of Mutual Funds: Optimal Fund Objectives and Industry Organization," Yale School of Management Working Papers ysm219, Yale School of Management. [Downloadable!]
  6. 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. [Downloadable!] (restricted)
  7. Peter Diamond, 1998. "Managerial Incentives: On the Near Linearity of Optimal Compensation," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 931-957, October. [Downloadable!] (restricted)
  8. Admati, Anat R & Pfleiderer, Paul, 1997. "Does It All Add Up? Benchmarks and the Compensation of Active Portfolio Managers," Journal of Business, University of Chicago Press, vol. 70(3), pages 323-50, July. [Downloadable!] (restricted)
  9. 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.
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  10. John R. Graham & Campbell R. Harvey, 2001. "Expectations of Equity Risk Premia, Volatility and Asymmetry from a Corporate Finance Perspective," NBER Working Papers 8678, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  11. Eichberger, Jurgen & Grant, Simon & King, Stephen P., 1999. "On relative performance contracts and fund manager's incentives," European Economic Review, Elsevier, vol. 43(1), pages 135-161, January. [Downloadable!] (restricted)
  12. Habib, Michel A. & Johnsen, D. Bruce & Naik, Narayan Y., 1997. "Spinoffs and Information," Journal of Financial Intermediation, Elsevier, vol. 6(2), pages 153-176, April. [Downloadable!] (restricted)
  13. 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, Oxford University Press for Society for Financial Studies, vol. 15(5), pages 1465-1497.
  14. Michael Brennan, 1993. "Agency and Asset Pricing," University of California at Los Angeles, Anderson Graduate School of Management 1147, Anderson Graduate School of Management, UCLA. [Downloadable!]
  15. Robert Gibbons & Kevin J. Murphy, 1990. "Relative performance evaluation for chief executive officers," Industrial and Labor Relations Review, ILR Review, ILR School, Cornell University, vol. 43(3), pages 30-51, February.
  16. Scharfstein, David S & Stein, Jeremy C, 1990. "Herd Behavior and Investment," American Economic Review, American Economic Association, vol. 80(3), pages 465-79, June.
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  17. Gibbons, R. & Murphy, K.J., 1989. "Relative Performance Evaluation For Chief Executive Officers," Working papers 532, Massachusetts Institute of Technology (MIT), Department of Economics.
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  18. Bengt Holmstrom, 1982. "Moral Hazard in Teams," Bell Journal of Economics, The RAND Corporation, vol. 13(2), pages 324-340, Autumn. [Downloadable!] (restricted)
  19. Nanda, Vikram & Narayanan, M. P. & Warther, Vincent A., 2000. "Liquidity, investment ability, and mutual fund structure," Journal of Financial Economics, Elsevier, vol. 57(3), pages 417-443, September. [Downloadable!] (restricted)
  20. Mark Grinblatt & Sheridan Titman, . "Adverse Risk Incentives and the Design of Performance-Based Contracts," Rodney L. White Center for Financial Research Working Papers 21-88, Wharton School Rodney L. White Center for Financial Research.
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