April 2000 UPDATED VERSION
Philip H. Dybvig, Heber K. Farnsworth, and Jennifer Carpenter
ABSTRACT
The evaluation and compensation of portfolio managers is an important problem for practitioners. Optimal compensation
will induce managers to expend effort to generate information and to use it appropriately in an informed portfolio
choice. Our general model points the way towards analysis of optimal performance evaluation and contracting in
a rich model. Optimal contracting in the model includes an important role for portfolio restrictions that are more
complex than the sharing rule. The agent's compensation gives the agent approximately to benchmark return plus
an incentive fee equal to a portfolio measure that is approximately the excess of return above the benchmark. This
measure is often used by practitioners but is simpler than the Jensen measure and other measures commonly recommended
in the academic literature. In addition to the excess return above the fixed benchmark, the manager is given some
additional incentive to take a position that deviates from the benchmark to remove an incentive to tend towards
being a "closet indexer." Efficient contracting involves restrictions on what portfolio strategies can
be pursued, and prior communication of the information gathered.
Subject: Delegated Portfolio Management; Contract Design; Portfolio Performance Measurement
Category: Theoretical
Carpenter: (212) 998-0352 jcarpen0@stern.nyu.edu
Dybvig: (314) 935-4569 dybvig@dybfin.wustl.edu
Farnsworth: (314) 935-4221 FARNSWORTH@olin.wustl.edu
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