Portfolio performance and agency

In this paper we analyze the optimal contract for a portfolio manager who can exert effort to improve the quality of a private signal about future market prices. We assume complete markets over states distinguished by asset payoffs and place no restrictions on the form of the contract. We show that trading restrictions are essential because they prevent the manager from undoing the incentive effects of performance-based fees. We provide conditions under which simple benchmarking emerges as optimal compensation. Additional incentives to take risk are necessary when information can be manipulated or else the manager will understate information to offset the benchmarking. (JEL D82, G11) The appropriate evaluation and compensation of portfolio managers is an ongo-ing topic of debate among practitioners and regulators. Although performance measurement and optimal managerial contracting are two sides of the same coin, the academic literature has largely considered the two questions sepa-rately. Typically, performance measurement has been studied in the context of models with realistic security returns, without consideration of the incentives created by the measure. Optimal contracting has been studied in informa