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Optimal Compensation for Fund Managers of Uncertain Type: The Information Advantages of Bonus Schemes

  • Alexander Stremme
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    Performance-sensitivity of compensation schemes for portfolio managers is well explained by classic principal-agent theory as a device to provide incentives for managers to exert effort or bear the cost of acquiring information. However, the majority of compensation packages observed in reality display in addition a fair amount of convexity in the form of performance-related bonus schemes. While convex contracts may be explained by principal-agent theory in some rather specific situations, they have been criticized, both by the financial press as well as the academic literature, on the grounds that they may lead to excessive risk-taking. In this paper, we show that convex compensation packages, though likely to be myopically not optimal, may serve as a device to extract information about the ex-ante uncertain type of portfolio managers. Optimal contracts are thus determined by the trade-off between maximizing short-run expected returns on one hand, and long-run informational benefits on the other. In a discrete-time model, combining dynamic principal-agent theory with the theory of learning by experimentation, we characterize optimal incentives schemes and optimal retention rules for fund mangers, consistent with empirical observations.

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    Paper provided by New York University, Leonard N. Stern School of Business- in its series New York University, Leonard N. Stern School Finance Department Working Paper Seires with number 99-029.

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    Date of creation: Oct 1999
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    Handle: RePEc:fth:nystfi:99-029
    Contact details of provider: Postal: U.S.A.; New York University, Leonard N. Stern School of Business, Department of Economics . 44 West 4th Street. New York, New York 10012-1126
    Phone: (212) 998-0100
    Web page: http://w4.stern.nyu.edu/finance/
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    1. Aghion, P. & Bolton, P. & Harris, C. & Jullien, B., 1990. "Optimal Learning By Experimentation," DELTA Working Papers 90-10, DELTA (Ecole normale supérieure).
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    4. Jensen, Michael C & Murphy, Kevin J, 1990. "Performance Pay and Top-Management Incentives," Journal of Political Economy, University of Chicago Press, vol. 98(2), pages 225-64, April.
    5. Fudenberg, Drew & Holmstrom, Bengt & Milgrom, Paul, 1990. "Short-term contracts and long-term agency relationships," Journal of Economic Theory, Elsevier, vol. 51(1), pages 1-31, June.
    6. Keller, Godfrey & Rady, Sven, 1999. "Optimal Experimentation in a Changing Environment," Review of Economic Studies, Wiley Blackwell, vol. 66(3), pages 475-507, July.
    7. Josef Lakonishok & Andrei Shleifer & Richard Thaler & Robert Vishny, 1991. "Window Dressing by Pension Fund Managers," NBER Working Papers 3617, National Bureau of Economic Research, Inc.
    8. Aghion, Philippe, et al, 1991. "Optimal Learning by Experimentation," Review of Economic Studies, Wiley Blackwell, vol. 58(4), pages 621-54, July.
    9. Jeffrey S. Banks & Rangarajan K. Sundaram, 1998. "Optimal Retention in Principal/Agent Models," New York University, Leonard N. Stern School Finance Department Working Paper Seires 98-006, New York University, Leonard N. Stern School of Business-.
    10. Paul Oyer, 1998. "Fiscal Year Ends And Nonlinear Incentive Contracts: The Effect On Business Seasonality," The Quarterly Journal of Economics, MIT Press, vol. 113(1), pages 149-185, February.
    11. Radner, Roy, 1985. "Repeated Principal-Agent Games with Discounting," Econometrica, Econometric Society, vol. 53(5), pages 1173-98, September.
    12. Judith Chevalier & Glenn Ellison, 1996. "Are Some Mutual Funds Managers Better Than Others? Cross-Sectional Patterns in Behavior and Performance," NBER Working Papers 5852, National Bureau of Economic Research, Inc.
    13. Goetzmann, W.N. & Ibbotson, R.G., 1990. "Do Winners Repeat? Patterns in Mutual Fund Behavior," Papers fb-_91-04, Columbia - Graduate School of Business.
    14. Goetzmann, W.N., 1993. "Attrition and Mutual Fund Performance," Papers 93-01, Columbia - Graduate School of Business.
    15. Khorana, Ajay, 1996. "Top management turnover An empirical investigation of mutual fund managers," Journal of Financial Economics, Elsevier, vol. 40(3), pages 403-427, March.
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