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 …show more content…

In this way, the principal may save on the remuneration she has to provide to the agent, at the risk however of exposing himself entirely to the effect of the common shock. Second, under reasonably general assumptions, a linear sharing rule is an optimal contract as it induces an optimal trade-off between risk sharing and effort inducement (Holmstrom and Milgrom, 1987). Hence, the optimal contract has a linear form in which the agent is paid a flat fee plus a share of the outcome, possibly defined in terms of a spread against a certain benchmark value. The share is optimally set
C 2006 The Author Journal compilation

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2006 Blackwell Publishing Ltd

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taking into account the relative risk aversion of the principal and the agent, as well as the need to motivate the agent to undertake costly effort. After this admittedly oversimplified description of a standard agency setting, we set out to discuss how the basic features outlined above can be extended to the particular form of agency relationship, which is the delegated portfolio management contract. The paper is structured as follows. In Section 2, we present the standard framework of the problem, and we then deal with the optimal compensation contract in a single-period set-up in Section 3. In Section 4, we extend the discussion to deal with a multi-period setting in which reputation concerns play an