Delegated Portfolio Management
DELEGATED PORTFOLIO MANAGEMENT: A SURVEY OF THE THEORETICAL LITERATURE
Livio Stracca European Central Bank
Abstract. This paper provides a selective review of the theoretical literature on
delegated portfolio management as a principal–agent relationship. The main focus of the paper is to review the analytical issues raised by the peculiar nature of the delegated portfolio management relationship within the broader class of principal– agent models. In particular, the paper discusses the performance of linear versus nonlinear compensation contracts in a single-period setting, the possible effects of limited liability of portfolio managers, the role of reputational concerns in a multiperiod framework, and the incentives to noise trading. In addition, the paper deals with some general equilibrium dimensions and asset pricing implications of delegated portfolio management. The paper also suggests some directions for future research.
Keywords. Adverse selection; Agency; Delegated portfolio management; Moral hazard; Principal–agent models
1. Introduction
In most industrialized countries, a substantial part of financial wealth is not managed directly by savers, but through a financial intermediary, which implies the existence of an agency contract between the investor (the principal) and a portfolio manager (the agent). Therefore, delegated portfolio management is arguably one of the most important agency relationships intervening in the economy, with a possible impact on financial market and economic developments at a macro level. Although there are no harmonized data across countries, the general view is that the trend towards delegated portfolio management has not been interrupted by the increased direct accessibility to financial markets witnessed in recent years, for example, through the Internet. Davis and Steil (2001) report that the share of household wealth managed by financial institutions has increased sharply in recent decades, in particular in the
Livio Stracca European Central Bank
Abstract. This paper provides a selective review of the theoretical literature on
delegated portfolio management as a principal–agent relationship. The main focus of the paper is to review the analytical issues raised by the peculiar nature of the delegated portfolio management relationship within the broader class of principal– agent models. In particular, the paper discusses the performance of linear versus nonlinear compensation contracts in a single-period setting, the possible effects of limited liability of portfolio managers, the role of reputational concerns in a multiperiod framework, and the incentives to noise trading. In addition, the paper deals with some general equilibrium dimensions and asset pricing implications of delegated portfolio management. The paper also suggests some directions for future research.
Keywords. Adverse selection; Agency; Delegated portfolio management; Moral hazard; Principal–agent models
1. Introduction
In most industrialized countries, a substantial part of financial wealth is not managed directly by savers, but through a financial intermediary, which implies the existence of an agency contract between the investor (the principal) and a portfolio manager (the agent). Therefore, delegated portfolio management is arguably one of the most important agency relationships intervening in the economy, with a possible impact on financial market and economic developments at a macro level. Although there are no harmonized data across countries, the general view is that the trend towards delegated portfolio management has not been interrupted by the increased direct accessibility to financial markets witnessed in recent years, for example, through the Internet. Davis and Steil (2001) report that the share of household wealth managed by financial institutions has increased sharply in recent decades, in particular in the