In this paper, we study the effect of relative (to a benchmark) performance evaluation on the provision of incentives for the search of private information under moral hazard when managers face exogenous portfolio constraints that limit their ability to sell short and purchase on margin.
A large number of mutual funds face portfolio constraints, which has implications for portfolio performance and asset pricing in a broader context. Almazan, Brown, Carlson and Chapman (2004) document that approximately 70% of mutual funds explicitly state (in Form N-SAR submitted to the SEC) that short selling is not permitted. This figure rises to above 90% when the restriction is on margin purchases. They present evidence on portfolio constraints being used to monitor the managerks effort.
Grinblatt and Titman (1989) and Brown, Harlow, and Starks (1996) argue that cross sectional differences in constraint adoption might be related to characteristics that proxy for managerial risk aversion. Agarwal, Boyson, and Naik (2009) show that hedged mutual funds mimicking hedge fundskinvestment strategies perform better than traditional mutual funds, on account of having more flexibility due to lesser portfolio constraints. Finally, portfolio constraints have been shown to be important in explaining the cross sectional stock return anomalies (Nagel (2005)).
This paper shows that portfolio constraints have important implications for management compensation and performance evaluation. Specifically, our paper makes three contributions. First, taking portfolio constraints as given, we solve analytically for the benchmark composition that maximizes the managerks effort expenditure. Second, analyzing the principals optimal contract, we show that, under portfolio constraints, relative performance evaluation may be optimal. Numerically, we solve jointly for the managerks incentive fee and the optimal benchmark. Third, under portfolio constraints, when the benchmark composition is endogenously determined, the principalks optimal benchmark choice will not necessarily coincide with the benchmark that maximizes the fundks Information Ratio (excess return per unit of tracking error volatility).
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Management Compensation and Market Timing under Portfolio Constraints
