Optimal Delegation Contract with Portfolio Risk

Uninformed investors (the principal) often delegate investments to institutions (the agent) with information advantages. However, conventional linear benchmarked contracts tend to cause excessive pegging to the benchmark and thus price distortion of stocks in the benchmark. This paper studies the optimal delegation contract when there is principal-agent friction. Specifically, it explores the impacts of incorporating the risk of invested portfolio in the contract on optimal strategies of the principal and the agent, and on equilibrium asset prices. When agency friction is severe, the optimal contract provides rewards for risk taking that mitigate pegging to the benchmark. Contrary to conventional benchmarking, compensation increases with benchmark performance to inspire the agent. In equilibrium, the principal invests in the index portfolio while the agent invests only in individual risky assets