Estimation Risk and Incentive Contracts for Portfolio Managers

The fiduciary relationship between portfolio managers and the investors they represent may be viewed as a principal-agent relationship, and therefore we have used the methodology from the agency literature in economics and finance to study the impact of existing compensation arrangements on the conflicts of interest between these two groups. In this paper we employ the assumptions of the Capital Asset Pricing Model and of estimation risk concerning beta to develop a model in which portfolio managers can, through effort, choose the parameters of the beta distribution. Our model entails moral hazard because the investor cannot observe the manager's action. Given certain utility functions we show that the presence of estimation risk leads the manager to choose a lower beta portfolio than otherwise and that no first best optimal contract exists. We also show that managerial divergent behavior is related to the divergence in risk preferences between the manager and the investor. By making slightly more stringent assumptions about preferences, we show that there exist some conditions under which the manager will provide more effort but also a riskier portfolio than the investor prefers. Finally we show that the investor will prefer a manager who is less risk averse than the investor.