Portfolio Delegation and Market Efficiency

Abstract

We develop a two-period general equilibrium model of portfolio delegation with competitive, differentially skilled managers and convex compensation contracts. We show that convex incentives lead to significant equilibrium mispricing, but reduce price volatility. In particular, price informativeness and volatility may exhibit opposite behaviour. Investors do not internalize the externality that their contract choice has on equilibrium prices. As a result, equilibrium incentives may be too strong or too weak and hurt investors as a whole. For example, investors' utility may be decreasing in the average managers' skill. Convex incentives amplify this negative externality. Indirect incentives due to future fund flows may induce investors to choose stronger convex direct incentives, amplifying inefficiencies even further. Inference of skill from performance is asymmetric: past bad performance is indicative of low skill, but past good performance is not indicative of high skill.

Keywords: portfolio delegation, optimal incentives, contracts, asymmetric information, informational efficiency

JEL Classification: G14, D86, G23, D53