On Relative Performance Contracts and Fund Managers Incentives

Abstract

For pension schemes, mutual funds, banks and other financial intermediaries, large portfolio decisions are increasingly delegated to fund managers. Recently, there has been growing concern that these managers seem to adopt extremely similar investment strategies. One possible explanation for this phenomenon may be found in reward schemes based on relative performance. We show how relative performance reward schemes may arise as optimal contracts. Our focus is the fund owners-fund manager relationship in which the manager, before making a portfolio decision on behalf of the owners, may acquire, at some cost, information that is not available to the owners. Payment schemes based on relative performance afford the owners tighter control of their manager's activities. However, if two managers of different funds both accept contracts that depend on their relative as well as absolute performances, then there may exist equilibria in the managers' subgame that result in undesirable outcomes for the owners.