Delegated Portfolio Management

13512 Words55 Pages
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
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Finally, Section 6 concludes.
2. A Benchmark Single-Period Setting 2.1 Some Stylized Facts about Delegated Portfolio Management

Recent decades have witnessed a sharp increase in the institutionally managed savings, both in absolute terms and relative to household financial wealth (Davis and Steil, 2001; BIS, 2003). As a result, institutional ownership is an increasingly dominant feature of developed financial markets. Delegated portfolio management is a complex phenomenon which encompasses different segments. The mutual fund industry is predominantly characterized by middle-aged households investing individually in sometimes relatively standardized products. By contrast, pension funds are predominantly managed by corporate treasures, who often delegate the asset management to a third party, thus creating an additional layer of agency. As emphasized by Lakonishok et al. (1992b), corporate treasures often make recourse to investment counsellors for reasons which go beyond the optimization of asset allocation. Non-economic factors such as handholding and generally direct interaction are likely to play an important role in the pension fund industry, while funds allocation is more based on past performance in the mutual fund industry. Another important stylized fact of the delegated portfolio management industry is the poor performance of active management compared with a passive benchmark (Malkiel, 1995; Gruber, 1996).
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