Optimal Portfolio Delegation with Imperfect

Information∗
Tao Li† and Yuqing Zhou‡
First Draft: December 2006
This Version: April 8, 2009

Abstract

This paper investigates the contracting problems that arise in portfolio delega-
tion with imperfect information. In particular, this research studies the role of
stock indexes in the design of incentive fees in portfolio delegation. We show
that in a situation in which the fund manager possesses no superior security se-
lection skill and the portfolio choices cannot be contracted upon, stock indexes
serve as important instruments for achieving optimal risk-sharing between the
investor and the fund manager. While the current literature mainly focuses on
the implications of benchmarking either for a given class of contract forms or for
a specific type of utility functions, we characterize the optimal contracts with
general preferences and incorporate stock indexes into the analysis. Our results
indicate that stock indexes can be used to recoup or reduce the efficiency loss
caused by the uncontractibility of portfolio choices, and can provide a valuable
service even if these indexes are imperfectly constructed.

Keywords: Benchmark, Risk Sharing, Incentive, Optimal Contract, Portfolio

Delegation

JEL Classifications: D80, G11, G30, J33, M52

∗
We would like to thank the seminar participants of Workshop in Contract Theory at CUHK (De-
cember 2006), 2007 Econometric Society North American Summer Meetings and European Meetings
for helpful comments and suggestions.
†
Department of Economics and Finance, City University of Hong Kong, 83 Tat Chee Avenue,
Kowloon, Hong Kong, Email: taoli96@gmail.com.
‡
Department of Finance, Faculty of Business Administration, The Chinese University of Hong
Kong, Shatin, N.T., Hong Kong, Email: zhou@baf.msmail.cuhk.edu.hk.

Electronic copy available at: http://ssrn.com/abstract=951707

1 Introduction

The agency relationship arising in portfolio delegation and the resulting contracting
problems are quite different from those studied by the classical principal-agent the-
ory. First, the fund manager’s action space may include both efforts on information
collection and/or production and portfolio choices.1 As Diamond (1998) has noted in
the context of the managerial compensation design, “Managers are called on to make
choices as well as to make efforts.” This is especially relevant for delegated portfolio
management, in which the freedom of choices for the fund managers is much larger
than that faced by a firm manager. Thus the choice aspect is as important as, if not
more important than, the effort dimension in the design of incentive fees in the in-
vestment fund industry. Second, the wealth process of a managed portfolio has to be
endogenously determined through a well defined trading strategy that satisfies budget
constraints. Thus one cannot arbitrarily assume an exogenous relation between the
actions and payoffs in portfolio delegation as a typical principal-agent model does.2

These issues make the standard principal-agent models difficult or impossible to

apply to the delegated portfolio management. Li and Zhou (2005), which characterizes
the second-best contracts that can be written only on the final wealth or return of
portfolios, is one of the first attempts to move along this line. Built on Li and
Zhou (2005), this paper further investigates the contracting problems in portfolio
delegation with imperfect information. In particular, this research studies the role
of stock indexes in the design of incentive fees in the investment fund industry. The
model goes as follows. An investor, or a fund company, hires a fund manager to
1
The action space in the terms of portfolio choice can be very rich, e.g., in a continuous-time
setting. This richness of the agent’s action space has important implications on the structure of the
optimal compensation schemes, see, for instance, Diamond (1998) and Mirrlees and Zhou (2005a,
2005b).
2
This does cause some additional technical problems that are absent in the classical principal-
agent model. This can be seen clearly from a model in a continuous-time setting, where, because of
the budget constraint, the drift rate and the diffusion rate of the underlying wealth process cannot
be controlled independently.

Electronic copy available at: http://ssrn.com/abstract=951707

manage her portfolio. The fund manager has no superior security selection skill3 in
the sense that she has no private information compared to other fund managers in the
market. We assume that the investor and fund manager share the same information
or belief about the security markets at aggregate level, which can be summarized
by assuming that both the investor and fund manager agree on the distribution of
the price density function in the case of complete markets. However, at the micro
level the fund manager does have better information than the investor about the
risk characteristics of individual securities, which partially justifies the necessity of
portfolio delegation.4 Given this, our model addresses the contracting problems in a
situation in which the fund manager does not have superior security selection skills
(compared to other fund managers, of course) and her portfolio choice cannot be
contracted upon. As a result, in designing incentive fees, the investor must rely on
other variables, say stock indexes, to motivate the fund manager to make the right
choice.

We show that the first-best results are always achievable if there is a market
portfolio, which is, by definition, perfectly correlated with the underlying state price.
Hence the role of the market portfolio in portfolio delegation is to recoup the efficiency
loss due to the different preferences between the investor and her fund manager.
However, the market portfolio may not be observable hence cannot be contracted upon
in reality, thus at best some imperfect observables, e.g., a stock index, can be used
in the design of the pay schemes for fund managers. In this case, the efficiency loss
of the second-best contracts cannot be eliminated completely and the improvement
of efficiency depends on how well the index correlates with the market portfolio or
state price. We characterize the second-best contracts with imperfect information
under rather general conditions by an integral equation, which can be solved by
piece-wise ordinary differential equations (ODEs). Overall, our results shed light on
3
One of the reasons why a manager who possesses no superior skill is needed is the opportunity
costs for investors to constantly monitor the markets and trade in a continuous-time setting, see
Mamaysky and Spiegel (2002) for more elaborations on this.
4
It is much less costly to collect market data on information at aggregate level than at micro
level. In fact, as shown in this paper, all investors need to achieve the first-best results is the market
portfolio, if it is observable hence can be contracted upon.

2
and identify another role of stock indexes in the compensation of fund managers: it is
used to recoup or reduce the efficiency loss of the second-best contracts. This function
of stock indexes played in fund managers’ compensations has been largely ignored in
the literature.

There are several important aspects that justify our model’s assumptions and
confirm their empirical relevance. First, there is extensive empirical evidence showing
that, historically, the majority of fund managers fail to beat the market, even if many
of them claim to be “active” fund managers. Thus, the assumption that the fund
manager has no superior security selection skills has some empirical relevance in
practice. Second, in reality, the structure of a fund manager’s compensation mainly
depends on the past performance of the fund under management, on the fund’s total
return relative to a prespecified benchmark, and on bonuses that are related to the
profitability of the firm that employs her (see, e.g., Chevalier and Ellison (1997)
and Farnsworth and Taylor (2006)). While investors may place some restrictions on
the fund manager’s portfolio choice, the fund manager has large freedom in trading
assets in the markets and her incentive fees are seldom based on trading strategies
directly. As a result, it is reasonable to treat the fund manager’s portfolio choice as a
moral hazard variable, and to treat the conflicts of interest arising from the different
preferences between the investor and fund manager as a fundamental issue in the
fund management industry. Third, although our model only deals with a simple
agency relationship, that is, an investor versus a fund manager, our analysis has
general implications to the situation where investors (or fund companies) hire many
managers simultaneously.5 For example, the case of multiple fund managers can be
made precise when investors’ utility is exponential and the asset classes managed
by different fund managers are relatively independent. Finally, our model confirms
the popular view held by practitioners that the use of benchmarks can be valuable,
5
In reality, the agency relationship is multi-layer and complex. In general, investors (or fund
companies) allocate their capital (usually under the recommendation of agents) among many different
fund managers. However, the simple one-to-one agency relationship considered in our model will
not disappear, and investors (or fund companies) still have to face the individual fund manger’s
incentive problem after the asset allocation decision has been made.

3
but may be for a different reason. In our context, the stock indexes are valuable
because they can be used to recoup or reduce the efficiency loss caused by the fund
manager’s portfolio choice, and not to induce the fund manager’s efforts in collecting
information. As a direct application, our model is mostly relevant to a wide range of
“passively” managed funds, the major objective of which is to balance the portfolio’s
risk and return that align with investors’ preferences and the managers of which need
a right incentive to do so.

Overall, we believe that the problem arising from the conflicts of interest due to
the different preferences between the investors and fund managers is among the most
fundamental ones in the fund management industry. It has to be fully addressed in
the first place before a full-fledged theory of portfolio delegation can be developed.
Our results indicate that a properly constructed stock index that is independent of
preferences can solve or at least mitigate these conflicts of interest. Interestingly,
some benchmarks already available in the markets exhibit some required features of
the theoretically constructed market index, and thus can be used to align the interest
of the fund manager with that of the investors to achieve optimal or near optimal
risk-sharing. As a result, our model has set up a foundation upon which further moral
hazard variables can be introduced to enrich the model.

On the technical side, we follow the method developed by Li and Zhou (2005) to
solve the optimal contract with imperfect information. Similar to Li and Zhou (2005),
we show that the problem of finding the optimal contract can be converted into the
one that solves a nonlinear second-order ordinary differential equation (ODE). As a
result, the first- and second-best contracts can be fully analyzed and compared. We
show that, for a given stock index, the first-best risk sharing can be achieved if and
only if the stock index is perfectly correlated with the state price. In particular, when
the investor and fund manager have “similar” preferences, an incentive fee based
on final wealth alone is sufficient to achieve the first-best risk sharing (see Li and
Zhou (2005)). In case the stock index is imperfectly constructed or a market index is
impossible to construct, numerical calculation shows that the efficiency loss is small
if the market index is highly correlated to the price density function.

4
 There are a number of papers that study the role of benchmarking in different
contexts. Most of them focus on the effects of benchmarking on the fund manager’s
trading strategy for a given class of compensation schemes (see Roll (1992) and Basak,
Pavlova, and Shapiro (2003) and the reference therein), and the predictions are mixed.
Stoughton (1993) and Admati and Pfleiderer (1997) study the adverse consequences
of benchmarking in the presence of private information for a given class of compensa-
tion schemes, and show that in general the use of benchmarks will not induce the fund
manager to exert high efforts in collecting information. Ou-Yang (2003) and Dybvig,
Farnsworth, and Carpenter (2004) treat the compensation scheme with benchmarks
endogenously but focus on specific utilities. In contrast, we solve the optimal compen-
sation scheme with imperfect information and general preferences in the second-best
world. Kraft and Korn (2004) also consider the role of the market portfolio played in
the fund managers’ compensations. However, they mainly focus on the the first-best
cases and do not characterize the second-best contracts when the market portfolio is
unobservable and hence cannot be contracted upon.

The paper is organized as follows. The next section studies the contracting prob-
lem with imperfect information in an abstract setting. The second- and first-best
contracts conditional on some signals are characterized in Section 3. The relation
between the efficiency and the quality of information is also discussed in this section.
Section 4 offers a detailed example in a continuous-time setting, in which some fea-
tures and implications of the optimal, especially the second-best, contracts are further
studied. Section 5 concludes the paper. All proofs are provided in the appendix.

2 The Basic Framework

Consider a setting in which an investor or a fund company (the principal) wishes

to hire a fund manager (the agent) to manage her portfolio. The portfolio return is
realized over a continuum of states in a single period. Let (Ω, F, P ) be the space
of states endowed with a probability measure and ω ∈ Ω be a state. As a start,
we assume that there exists a rich set of financial securities such that the financial

5
markets under consideration are complete. If a market is complete, then there exists a
unique state price function p (ω) per unit probability over Ω. The portfolio returns are
affected by the agent’s actions, or individual security selections in the portfolio. Thus,
the incentive scheme designed by the principal matters in order to motivate the agent
to act in the best interest of the principal. If the agent’s action can be observed, or,
if the principal can costlessly distinguish the payoff characteristics of the universe of
securities in the financial markets, then the contracting problem between the principal
and the agent would be relatively straightforward; the contract would simply specify
the exact portfolio of securities to be selected by the agent and the compensation
that the principal promises to provide in return should the order be followed exactly.
However, if it is too costly for the principal to distinguish the payoff characteristics of
the universe of securities, then the contract can no longer specify the agent’s security
selection in an effective manner. Under this circumstance, the principal must design
a compensation scheme in a way that indirectly gives the agent an incentive to select
the correct set of securities. Li and Zhou (2005) study a case in which the only way
for the principal to get the agent to select a correct portfolio is to relate her pay to
the realization of the portfolio return, which is random. In this paper, we focus on
the use of imperfect information for the efficiency improvement of the contract.

To be more specific, let w ≥ 0 be the final wealth of the selected portfolio and
w (ω) be the realization of the final wealth over Ω, which is observable. In addition,
a signal s(ω), possibly vector valued, can be observed by both the principal and
the agent (common knowledge and verifiable), and can consequently be contracted
upon. A compensation scheme specifies the agent’s wage as a function of the observed
final wealth and the signal y(w, s). Let the principal’s utility function be u(·) and
the agent’s utility be v (·) , where u(·) and v(·) are independent of states, increasing
and concave over the interval [0, ∞). We also assume that the utilities are twice
differentiable,6 and their first-order derivatives satisfy u0 (∞) = v 0 (∞) = 0. If the
final wealth is w, the net benefit for the principal is assumed to be α(w, s) − y(w, s),
where 0 < α(w, s) ≤ w. When α(w, s) = w, our model is a typical principal-agent
problem. It can be interpreted as a large investor hiring a money manager to manage
6
The differentiability are not necessary but for convenience.

6
his portfolio.7 In general, α(w, s) is used to model a situation in which the principal
may be an institution or may act as an agent of large number of investors, and
thus only receive a portion of the realization of the final wealth either explicitly as a
management fee (e.g., a contract between a fund company and investors) or implicitly
through the flow of new funds.

The principal will delegate an initial wealth w0 for the agent to manage, and
design a pay schedule y (w, s) to induce the agent to act in her best interest. Given
a compensation scheme y (w, s) , under the budget constraint, the agent will select a
portfolio such that his own expected utility is maximized. Therefore, there exists an
explicit conflict of interests between the principal and the agent, and it is interesting
to see how the principal and the agent share the risks and what the optimal contracts
are. To formalize these ideas, let the agent’s action space A be defined by
Z
A = {w (ω) ≥ 0| p(ω)w(ω)dP (ω) ≤ w0 }, (1)
Ω

where the last term in equation (1) is the budget constraint. In other words, the action
space A consists of all random variables over Ω that satisfy the budget constraint.
In contrast to those one-dimensional (or low-dimensional) action spaces studied in
the agency models in existing literature, ours is “large” in the sense that it is infinite
dimensional. Let the agent’s reservation utility be v0 . Formally, the model goes as
follows: Z
max u(α(w, s) − y(w, s)) dP (ω) (2)
y(w,s),w(ω) Ω
subject to Z
v(y(w, s)) dP (ω) ≥ v0 (3)
Ω
and Z
w(ω) ∈ arg maxŵ(ω)∈A v(y(ŵ(ω), s)) dP (ω), (4)
Ω

where equations (3) and (4) are the standard participation constraint and incentive
constraint, respectively. The solution y(w, s) to this contract problem is the second
7
Much work in this literature has been done under such a specification. See Dybvig, Farnsworth,
and Carpenter (2004) and the references therein.

7
best, whereas the solution y(w, s) to (2) and (3) only is the first best that is Pareto
efficient.

The contracting problem above can be rewritten in terms of distribution condi-

tional on the signal s.
Z Z
max ds fs (s) u(α(w, s) − y(w, s)) dP (ω|s) (5)
y(w,s),w(ω) Ω

subject to Z Z
ds fs (s) v(y(w, s)) dP (ω|s) ≥ v0 (6)
Ω
and Z Z
w(ω) ∈ arg max ds fs (s) v(y(ŵ(ω), s)) dP (ω|s), (7)
ŵ(ω)∈A Ω
where P (ω|s) is the conditional distribution on s and the agent’s action space is
rewritten as
Z Z
A = {w (ω) ≥ 0| ds fs (s) p(ω)w(ω)dP (ω|s) ≤ w0 }. (8)
Ω

For the case in which no signal s is involved in the pay schedule y, the contracting
problem (5)-(7) is studied in Li and Zhou (2005). Following Li and Zhou (2005), we
reformulate the model in terms of distributions. We note that, given our model setup
in that both the principal’s utility and the agent’s utility are independent of state ω,
it is well-known, in the literature of portfolio choice without agency problem, that the
states only need to be distinguished by the state price p and the signal s when the
financial markets are complete. This is also true for portfolio delegations. We will
use f and F as probability density and cumulative distribution functions, respectively
and use subscripts to distinguish different variables. Specifically, let fs and fp be the
density functions of signal s and state price p, and write the joint distribution of p
and s as fs (s)fp|s (p), where fp|s (p) is the conditional probability density of state price
p on s. Also let fw (w) be the distribution functions of wealth w (ω). Note that fs , fp ,
hence fp|s are exogenously given, whereas fw (w) is the agent’s choice variable. For
simplicity, we further assume fp|s is continuous and first-order differentiable.8
8
These assumptions are not crucial to solve the contracting problems, but rather for convenience.
In addition, the state price density functions can not be arbitrarily specified; there should be no
arbitrage opportunity. Relevant restrictions are given explicitly when we work with specific examples.

8
 Now define feasible action spaces in the terms of state price and wealth distribution
as Z Z
Ap = {w(p, s) ≥ 0| ds fs (s) pw(p, s)fp|s (p) dp ≤ w0 } (9)

and
Z Z
−1
Aw = {fw|s (w) ≥ 0| ds fs (s) Fp|s (1 − Fw|s (w))wfw|s (w) dw ≤ w0 }, (10)

where we have used the following

−1
p = Fp|s (1 − Fw|s (w)), (11)

to rewrite the budget constraint in terms of wealth distribution. Equation (11) implies
that that w is a nonincreasing function of p that reduces the size of the agent’s action
space, and seems to be restrictive. However, the optimal choice is always within the
agent’s action space Aw , as shown by the following lemma.

Lemma 1 Take an arbitrary utility function G(w, s) such that

Z
max G(w(ω), s(ω)) dP (ω)
w(ω)∈A Ω

exists. Then
Z Z
max ds fs (s) G(w(ω), s) dP (ω|s)
w(ω)∈A Ω
Z Z
= max ds fs (s) G(w(p), s)fp|s (p) dp
w(p,s)∈Ap
Z Z
= max ds fs (s) G(w, s)fw|s (w) dw,
fw|s (w)∈Aw

where Ap and Aw are defined in equations (9) and (10), respectively.

Notice that the optimizations are pointwise in the dimension of the signal s. Based
on this observation, Lemma 1 is a straightforward extension of a similar result in Li
and Zhou (2005) without a signal or information.

Now Lemma 1 enables us to reformulate the agent’s problem in the terms of wealth
distribution, hence the principal’s problem represented by equations (5)-(7) can be

9
reformulated as follows:
Z Z
max ds fs (s) u(α(w, s) − y(w, s))fw|s (w)dw (12)
y(w,s),fw|s (w)

subject to Z Z
ds fs (s) v(y(w, s))fw|s (w) dw ≥ v0 (13)

and Z Z
fw|s (w) ∈ arg max ds fs (s) v(y(w, s))fˆw|s (w) dw (14)
fˆw|s (w)∈Aw

To solve the principal-agent problem (12)-(14), the method we are going to use
here is the basic technique in the calculus of variations. The basic idea goes as follows.
Suppose that fw|s (w) is an optimal solution, then perturb fw|s (w) by ² (s) η (w, s),
where ²(s) is a small constant for each s and η is an arbitrary integrable function that
R R R
satisfies η(w, s) dw = 0 for each s. Such a restriction makes sure ds fs (s) [fw|s (w)+
²η(w, s)] dw = 1. This is analogous to the finite dimensional case, in which η is a di-
rectional vector. The fact that fw|s is an optimal solution implies that all directional
derivatives at fw|s for each s are zero. The details for applying this technique are
provided in Li and Zhou (2005).

To solve the principal’s contracting problem, we first need to solve the agent’s
problem, the resulting Lagrange of which is
Z Z
V(fw|s , λ, λf ) = ds fs (s) v(y(w, s))fw|s (w) dw
·Z Z ¸
−1
−λ ds fs (s) fw|s (w)Fp|s (1 − Fw|s (w))w dw − w0
Z Z
+ ds fs (s) λf (w, s)fw|s (w) dw, (15)

where λ is positive constant and λf is a nonnegative function of wealth w and sig-

nal s, which is equal to zero if fw|s (w) > 0. As indicated by the Lagrange V, the
maximization over signal s can be done state-by-state or point maximization. This
observation simplifies the problem significantly. That is, for each s, the agent’s prob-

10
lem is equivalent to choosing fw|s (w) to maximize
Z ·Z ¸
−1
v(y(w, s))fw|s (w) dw + λ fw|s (w)Fp|s (1 − Fw|s (w))w dw − w0
Z
+ λf (w, s)fw|s (w) dw.

This problem is similar to what has been studied in Li and Zhou (2005).

Lemma 2 Given a pay schedule y(w, s). Suppose the agent’s problem has an optimal
solution.9 Then the necessary and sufficient condition for optimality is that, for any
s, there exist constants, λ > 0, λ` (s), and a density function fw|s (w) ≥ 0 such that
Z w
−1
x̃(w, s) ≡ λ Fp|s (1 − Fw|s (t)) dt + λ` (s), (16)
`

where x̃(w, s) is the concavification of the agent’s utility function v(y(w, s)) and ` is an
arbitrary number such that fw|s > 0. Furthermore, fw|s (w) ≡ 0 for w ∈ {t|v(y(t, s)) 6=
x̃(t, s)}.

An immediate implication of Lemma 2 is that we can restrict our feasible pays

that make the agent’s indirect utility x(w, s) = v(y(w, s)) concave in w. All other
feasible pay schedules have an equivalent “concave” pay that is different only on the
set of fw|s = 0. This observation enables us to further simplify the principal’s problem
by replacing the incentive constraint by equation (16). Lemma 2 makes it legitimate
to use the first-order approach in solving the contracting problem.

Specifically, let x(w, s) = v(y(w, s)), therefore, y(w, s) = v −1 (x) = h(x(w, s)) for
fixed s. Since v (y) is increasing and concave, h(x) is increasing and convex. The
principal’s problem is then reformulated as follows10
Z Z
max dsfs (s) u(α(w, s) − h(x(w, s)))fw|s (w) dw (17)
x,fw|s ∈Aw

9
For example, if y(w, s) is bounded above by a linear function for all s, then x(w, s) will have an
optimal solution.
10
The signals in α and in pay schedule y could be different. In this case, the contracting problem
can be solved by perturbing fw|s1 ,s2 and fs becomes a joint distribution of s1 and s2 .

11
subject to Z w
−1
x(w, s) = λ Fp|s (1 − Fw|s (t)) dt + λ` (s), (18)
`

where λ > 0 and λ` (s) are free variables, which are constrained by
Z Z
ds fs (s) x(w, s)fw|s (w)dw ≥ v0 . (19)

The reformulation of the original problem leads to equations (17)-(19), in which

the principal selects x(w, s) and fw|s (w) to maximize his utility u subject to the
first-order condition constraint (18) plus the participation and budget constraints.

Indeed, x (w, s) and its concavification x̃(w, s) are identical in a distribution sense,
which is exactly what matters in our principal-agent problem. If x (w, s) is concave
and nondecreasing for each s, then x (w, s) = x̃ (w, s) . Equation (18) alone also reveals
an important feature of the optimal contract. That is, the optimal contract must be
designed in such a way that the compensation is a nondecreasing function of the final
wealth. Of course, to obtain additional features of the optimal contract, we need to
solve the principal’s maximization problem. Lemma 2 tells us that the principal only
needs to focus on the class of nondecreasing and concave functions in the selection of
x (w, s).

Our discussions so far lead us to conclude that, on the one hand, for any smooth,
increasing and concave indirect function x(w, s) and a number λ > 0 there exists a
distribution function
1
Fw|s (w) = 1 − Fp|s ( x0 (w, s)) (20)
λ
such that equation (18) is satisfied. In other words, for any x(w, s), there is a unique
fw|s (w) that implements it. On the other hand, for any distribution function fw|s (w)
and λ > 0, there exists a unique x(w, s) that satisfies equations (18) and (19).

12
3 The Optimal Contracts

3.1 The Second-Best Contracts

In this section we characterize the optimal contracts of the agency problem discussed
in the previous section. Define
Z
s
U (fw|s , λ, λ` , λw , λv , λf ) = u (α(w, s) − h(x(w, s))) fw|s (w) dw
·Z ¸
−1
− λw fw|s (w)Fp|s (1 − Fw|s (w))w dw − w0
·Z ¸
+ λv x(w, s)fw|s (w) dw − v0
Z
+ λf (w, s)fw|s (w) dw, (21)

where λ > 0, λw > 0, λv ≥ 0, and λf (w, s) ≥ 0 if fw|s (w) = 0. The Lagrangian for
the principal’s maximization problem is
Z
U(fw|s , λ, λ` , λw , λv , λf ) = U s (fw|s , λ, λ` , λw , λv , λf )fs (s) ds.

This means that maximizing U is equivalent to maximizing U s for all s.

Note that, in addition to the budget and the individual rationality constraints, the
objective function U is also dependent on two choice variables λ and λ` (s). These two
variables can be handled separately from the function fw|s (w) by point maximization.

Proposition 1 For any given multipliers λw and λv , and a density function fw|s (w),
the objective function U is a concave function of (λ, λ` (s)). At optimum, (λ, λ` (s))
must satisfy the following first-order conditions
Z Z
∂U 1
=− ds fs (s) fw|s (w)[x(w, s) − λ` (s)][u0 h0 − λv ] dw = 0, (22)
∂λ λ
Z
∂U
= − fw|s (w)[u0 h0 − λv ] dw = 0 (23)
∂λ` (s)
for all s. In addition, the last equation implies λv > 0, that is, the participation
constraint must be binding at optimum.

13
 To determine fw|s , we use a variational technique as illustrated in the case of the
agent’s problem.

Proposition 2 Fixed (λw , λv , λ, λ` (s)). The first-order necessary condition for an

optimal solution fw|s to the contract problem is that there exists a function c(s) such
that
µ ¶
λw
u(α(w, s) − h(x(w, s))) + λf (w, s) + λv − x(w, s)
λ
Z w µZ a ¶
1 0 0
+λ (u h − λv )fw|s (t) dt da = c(s) (24)
` fp|s (p) 0

−1
holds almost everywhere, where p = Fp|s (1 − Fw|s (a)).

As shown in Li and Zhou (2005), this condition can handle corner solutions quite
easily, e.g., α is discontinuous and/or nondifferentiable at some points. However, to
ease the exposition, we only focus on the interior solutions in this paper.

For the region(s) in which λf (w, s) = 0, a differential equation can be derived

to further investigate the property of the optimal solutions. Taking derivatives with
respect to w to the first-order condition (24) implies that
Z w
d[u + (λv − λw /λ) x] λ
+ [u0 h0 − λv ]fw|s (t) dt = 0, (25)
dw fp|s (p) 0
−1
where p = Fp|s (1 − Fw|s (w)). This differential-integral equation becomes an ordinary
differential equation by taking derivatives one more time and using the fact that
1
fw|s (w) = − fp|s (x0 /λ)x00 .
λ
Define 0
0 0 0 0 0 0 0
fp|s
D(s) = {w|β − 2u h + (u [α − h x ] + (β − λv )x ) < 0}, (26)
λfp|s
where β = 2λv − λw /λ and the prime denotes the derivatives with respect to w.

Proposition 3 Suppose u(α(w, s) − h(x)) is a concave function of (w, x) for all s.

Then λf (w, s) ≡ 0 for all (w, s).

14
 In addition, the agent’s indirect utility, x = v(y), satisfies the following ordinary
differential equation (ODE)

2
[β − 2u0 h0 ] x00 + u00 [α0 − h0 x0 ] − u0 h00 [x0 ]2 + u0 α00
0
00 0 0 0 0 0
fp|s (p)
+ x (u [α − h x ] + (β − λv )x ) = 0, (27)
λfp|s (p)

which has a unique solution in D(s), given a set of boundary conditions (x(`), x0 (`)),
where p = x0 /λ, where α0 is the first-order derivative with respect to w.

The optimal pay schedule y also satisfies an ordinary differential equation (ODE)
as:
v 00
(βv 0 − 2u0 )y 00 + (βv 0 − u0 )[y 0 ]2 + u00 [α0 − y 0 ]2 + u0 α00
v0
0
£ 0 00 00 0 2
¤ 0 0 0 0 0
fp|s (p)
+ v y + v [y ] (u [α − y ] + (β − λv )v y ) = 0, (28)
λfp|s (p)

where p = v 0 y 0 /λ. However, it seems to be easier to work with the agent’s indirect
utility x. The contracting problem can be solved by solving the ODE (27) and the
multipliers are determined by the following integrals.

The first-order conditions for (λ, λ` (s)) in equations (22) and (23) can be rewritten
as follows Z Z ∞
ds fs (s) fp|s (x0 /λ)x00 x[u0 h0 − λv ] dw = 0, (29)
0
and Z ∞
fp|s (x0 /λ)x00 [u0 h0 − λv ] dw = 0, (30)
0
for each s. And the budget and participation constraints become
Z Z ∞
ds fs (s) wfp|s (x0 /λ)x00 x0 dw = −λ2 w0 (31)
0

and Z Z ∞
ds fs (s) fp|s (x0 /λ)x00 x dw = −λv0 . (32)
0

When we have solved for x(w, s), the optimal pay schedule is given by y = h(x(w, s)).

15
3.2 The First-Best Contracts

It is clear that the second-best contracts are equivalent to the first-best one if the
signal s is the same as the underlying state ω. The first-best contract consists of a
final wealth function w(ω), which is equivalent to a detailed instruction of portfolios,
and a pay schedule y(ω) such that the pair (w(ω), y(ω)) maximizes the principal’s
expected utility under the budget constraint:
Z
max u(α(w(ω), s) − y(ω)) dP (ω) (33)
w(ω)∈A, y(ω) Ω

subject to the participation constraints:

Z
v(y(ω)) dP (ω) ≥ v0 . (34)
Ω

This maximization problem is straightforward when u(α(w, s) − y) is concave for all

s and y, but it becomes complicated when α(w, s) is convex. Therefore, it is helpful
to reformulate the problem into the principal’s choosing the distribution of wealth fw
instead of w. However, we cannot directly apply Lemma 1 to transform the problem
into choosing fw because of the additional term y(ω).

Lemma 3 The first-best pay schedule y(ω), which together with w(ω) solves the max-
imization problem (33)-(34), can be written as y(w(ω), s).

Lemma 3 shows we can replace y(ω) by y(w(ω), s) in the maximization problem

(33)-(34). Then, applying Lemma 1 to u + λv implies that the first-best contracting
problem is equivalent to
Z Z
max ds fs (s) u(α(w, s) − y(w, s))fw|s (w) dw
fw|s (w)∈Aw , y(w,s)

subject to Z Z
ds fs (s) v(y(w, s))fw|s (w) dw ≥ v0 .

In addition, and for the sake of comparison with the case of the second best, we use
y(w, s) = h(x) = v −1 (x). Then the Lagrangian of the reformulated maximization
problem is as follows:
Z
L(fw|s , x, λw , λv , λf ) = Ls (fw|s , x, λw , λv , λf )fs (s) ds,

16
where
Z
s
L (fw|s , x, λw , λv , λf ) = u(α(w, s) − h(x))fw|s (w) dw
·Z ¸
−1
− λw Fp|s (1 − Fw|s (w))wfw|s (w) dw − w0
·Z ¸ Z
+ λv xfw|s (w) dw − v0 + λf (w, s)fw|s (w) dw.

Using the variational method that perturbs fw|s by ²f ηf (w, s) and x by ²x ηx (w, s),
where ²f and ²x are two constants and
Z Z
ηf (w, s) dw = 0 and ηx (w, s)fw|s (w) dw < ∞,

we immediately have the following.

Proposition 4 A pair (fw|s , x(w, s)) is a first-best solution to the principal’s problem
if and only if it satisfies the following first-order conditions
Z w
−1
u(α(w, s)−h(x(w, s)))+λv x(w, s)+λf (w, s)− λw Fp|s (1−Fw|s (t)) dt = C(s) (35)
`

and
[u0 (α(w, s) − h(x))h0 (x) − λv ] fw|s (w) = 0 (36)

almost everywhere for any ` such that fw|s (`) > 0, where C(s) is independent of w
and x.

Similar to the second-best case, the first-order condition (35) can be used to handle
corner solutions. However, the corner solutions are quite straightforward for the first-
best case, that is, replacing u + λv x + λf in equation (35) by the concavification of
u + λv x along the dimension w. Thus λf for the first-best case can be predetermined
hence the interior part of the solutions are solved by simpler conditions.

Corollary 1 If λf (w, s) = 0 at (w, s), then the first-best contracts are given by
µ ¶
0 −1 λw p
y(w(p), s) = [v ]
λv α0 (w, s)

17
and the final wealth is implicitly given by
µ ¶ µ ¶
0 −1 λw p 0 −1 λw p
α(w, s) = [u ] + [v ] ,
α0 (w, s) λv α0 (w, s)

where α0 (w, s) is the first-order derivative with respect to w, and λw and λv are de-
termined by the budget and participation constraints.

If u(α(w, s) − h(x)) is a concave function of (w, x) for all s, then λf (w, s) ≡ 0 for
all (w, s).

Corollary 1 shows that the first-best contracts have closed-form solution for many
types of utility functions, e.g., the class of power utilities. In addition, Corollary 1
also reveals another interesting implication of the model. The first-best contracts do
not depend on any signals if the gross benefit of the principal α does not depend on
a signal even they are defined on a finer partition of the state space than the state
price. To achieve the first-best results, all it needs is the distribution of the state price
if it can be contracted upon. However, the second-best contracts can be improved by
conditioning on some signals even though they may not be perfect substitutes for the
state price.

3.3 Information and Efficiency

From the formulations of the contracting problems, it is clear that if the signal s
represents a finer partition on the state space Ω then the first-best contracts are
achievable. That is the second-best contracts are the same as the first-best ones. A
formal statement of this observation is as follows.

Theorem 1 If fp|s (p) is singular, then the second-best contracts are the same as the
first-best contracts.

An important and interesting question in portfolio delegation is: what state vari-
ables can be contracted upon? In practice, one may expect that since the security

18
price (or returns) processes can be observed, they can thus be contracted upon. How-
ever, casual observations tell us that practical pay schedules are hardly contracted
upon all the perceivable contingent price states. Enforceability, liquidity, and other
market imperfections prevent us from using all price information in the design of
compensation schemes. In addition, Theorem 1 shows that we do not need such full
price information to achieve the first-best results. If there exists an index of market
portfolio, which is perfectly correlated with the state price, then the first-best results
are always achievable by writing contracts based on this index. However, such an
index of the market portfolio may not exist or the market portfolio is not observable
in reality. In practice, many pay contracts use some passive indexes as a benchmark
in the design of compensation schemes because of high liquidity, easy enforcement,
and low contracting costs of these passive indexes. If these indexes are not perfect
substitutes for the state price itself, then how and in what degree are these imper-
fect signals able to improve the second-best results? To further explore this and
other contracting issues as well as to illustrate how the model can be applied, we will
go through a detailed example in a continuous-time setup, which is widely used in
modeling the dynamics of securities prices.

4 An Example in Continuous-Time

Our analysis in the previous sections can be carried over to a continuous-time model,
where passive indexes as contractible signals and manager’s dynamic portfolio selec-
tion issues can be addressed explicitly. In this section we will not seek generality in
applying our approach, but rather we will develop a specific model to highlight some
important points our approach can address. Such a model is also more relevant in
reality. In our continuous-time model, the time horizon is [0, T ], the principal (in-
vestors or a fund company) hires a manager to manage her initial wealth w0 at time 0
and the final wealth under the manager’s management at time T, which is random, is
denoted by w = WT . In practice, a fund under management normally has an external
fund inflow or outflow in the process of portfolio selection. While introducing an

19
exogenous fund flow causes no additional conceptual difficulty, we assume away the
external flow issue for simplicity. In other words, throughout this section we assume
that the manager’s trading strategies are self-financed.

There are N+1 securities available in the market for the manager to trade. One
is a risk-free bond, and the others are N risky securities. We assume that the bond’s
price St0 follows a deterministic process and has a constant short rate r, dS 0 = rS 0 dt.
For the N risky securities, their price process S = (S 1 , ..., S N )> is assumed to follow
a multi-dimensional geometric Brownian motion
dS
= µdt + σdB, S(0) > 0, (37)
S
³ 1 ´
dS N
where dS
S
, µ, and B are the transpose of dS
S1
, ..., SN
, (µ1 , ..., µN ) and (B1 , ..., Bd )
respectively, and σ is a N × d matrix. Note that B is a standard Brownian motion
in Rd on a probability space (Ω, F, P ) , with the standard filtration denoted by Ft .
We will further assume that the financial market is complete, thus set d = N without
loss of generality. Under such a condition, σ is a N × N matrix with a full rank.
¡ ¢>
A manager’s trading strategy is an admissible process π = π 1 , ..., π N that is
progressively measurable with respect to the filtration Ft and satisfies
µZ T ¶
2
E kπk dt < ∞
0

almost surely, where π i is the fraction of total wealth held in the i-th risky security.
Given a trading strategy, then the corresponding total wealth process as follows
dWt ¡ ¢
= r + π > (µ − r1) dt + π > σ dB; W0 = w0 , (38)
Wt
where 1 is a vector with all elements 1. Note that the manager’s trading strategy π
cannot be observed by the principal, thus cannot be contracted upon.

Given our model setup, the density process ξt at time T for the equivalent mar-
tingale measure is given by
µ ¶
1
ξT = exp − kθk2 T − θ> BT , (39)
2

20
where θ = σ −1 (µ − r1). The associated (deflated) state-price p at time T is p =
e−rT ξT , and the corresponding state price density function fp (p) can be written as
" µ ¶2 #
1 1 ln p − µp
fp (p) = √ exp − , (40)
2πσp p 2 σp
¡ ¢ √
where µp = − r + 12 kθk2 T and σp = kθk T .

Similar to the static case in the previous section, the principal designs compen-
sation schemes y (w, s) based on the final wealth and security price information s,
where s could be the information generated by a set of security (or portfolio) price
processes, and the principal and the fund manager maximize their expected utility
functions based on the final wealth at time T and the relevant information s. Ideally,
all security price processes, together with the wealth process, can be available for
contracting. In practice, however, it is very costly, if not impossible, to contract upon
all security prices due to liquidity problems or other market imperfections. Therefore,
practitioners typically design their contract based upon the final wealth and a set of
actively traded passive index funds (or portfolios of securities).

4.1 Stock Index

A passive index is formed by a subset of the N stocks. A trading strategy πs such

P i
that πs = 1 forms an index whose return follows a geometric Brownian motion by
equation (38). The gross return for this index over a period [0, T ] is given by
·µ ¶ ¸
> 1 > 2 >
Rs = exp πs µ − kσ πs k T + πs σBT ,
2
¡ ¢
which follows a normal distribution with a mean of µs = πs> µ − 21 kσ > πs k2 T and a
√
variance of σs = kσ > πs k T . Since p and s is joint normal, the conditional distribution
of state price p on the signal s = ln Rs is
" µ ¶2 #
1 1 σp
fp|s (p) = p exp − ln p − µp − ρ [s − µs ] , (41)
2π(1 − ρ2 )σp p 2(1 − ρ2 )σp2 σs
>
where ρ = − πσsp σσθs is the correlation between p and s. Thus a contract can use the
return of such an index to improve the efficiency.

21
 A special case in which an index is perfectly correlated with the state price offers
an ideal solution to the inefficiency of the second-best contracts if such an index exists
and is observable. From the discussion above, we know that the trading strategy for
such an index is γm σ > πs = θ, where γm is a constant scaler. This shows the trading
strategy for this index is £ ¤−1
σσ > (µ − r1)
πs = . (42)
1> [σσ > ]−1 (µ − r1)
Note that πs is a constant, preference-free, and is determined by the price parameters
only.11 This index is also known as the market portfolio in the asset pricing literature.
The relation between the state price p and the return of the market portfolio is
1
Rs = R0 p− γm , (43)

where ½· µ ¶ µ ¶ ¸ ¾
r1 1 1
R0 = exp πs> µ− − 1+ σp2 T
γm 2γm γm
and
£ ¤−1
γm = 1> σσ > (µ − r1) .

The parameter γm can be interpreted as the relative risk aversion coefficient of an

investor who optimally invests all wealth in the stocks.

4.2 Market Portfolio

As a benchmark, we first study the contracting problem in the case in which there is
a market portfolio that is observable, and hence can be used in contracts. As shown
in Theorem 1 the second-best contracts are the same as the first-best ones for this
case, so, we only need to solve the first-best contracts. We also assume that the gross
payoffs to the principal is:

α(w, s) = α0 w + α1 (w − w0 Rs eµ² T )+ = w0 [α0 R + α1 (R − Rs eµ² T )+ ],

11
See, e.g., Merton (1971, 1973).

22
where R = WT /W0 and Rs is the gross return of the market portfolio,12 given by
equation (43), and µ² is a constant. The option-like pays capture some incentives or
the effects of fund flows.

Since the gross payoff of the principal is convex, we have to concavify the welfare
function u + λv v for each Rs . This can be done by setting the following equations,
which are one of the direct implications of equation (35) in Proposition 4,

u0 [α0 (wl , s) − y 0 (wl , s)] + λv v 0 y 0 (wl , s)

= u0 [α0 (wh , s) − y 0 (wh , s)] + λv v 0 y 0 (wh , s) (44)
u(α(wh , s) − y(wh , s)) + λv v(y(wh , s)) − u(α(wl , s) − y(wl , s)) − λv v(y(wl , s))
= .
wh − wl
Here fw|s (w) ≡ 0 on the interval (wl , wh ). Due to the endogeneity of the multiplier
λv and the pay schedule y, this concavification cannot be done without solving the
contracting problem. Coupling these equations with the first-order conditions in
Proposition 4 gives us the solution of the first-best contracting problem.

Let us consider a specific example in which both of the principal and agent have
a power utility as
w1−γ
.
1−γ
Let γp and γa be the relative risk aversion coefficient of the principal and the agent,
respectively. We also use a certain equivalent pay wr to express the reservation of the
agent, which is defined as solving

wr1−γa
= v0 . (45)
1 − γa
This seems to be a sensible way of defining agents’ reservation because agents are
competing with pay levels rather than utility levels in the markets for money man-
agers.

12
The first-best contract for the case of an arbitrary benchmark portfolio is also straightforward
as given in Corollary 1.

23
Corollary 2 Suppose that both the principal and agent have power utility and the
market portfolio is observable. Then the optimal pay schedule is given by
 ³ ´− γ1

 λw p a
λv α 0
if p ≥ p̄
y(p) = ³ ´− γ1

 λw p a
λv (α0 +α1 )
if p < p̄

and the final wealth is given by

 ·³ ´ 1 ³ ´− γ1 ¸
−γ

 1 λw p p λw p a
 α0 α0
+ λv α0 if p ≥ p̄
w(p) = ·³ ´− γ1 ³ ´− γ1 ¸

 1 λw p p − γ1 λw p a
 α0 +α 1 α0 +α1
+ α 1 w0 R ² p m +
λv (α0 +α1 )
if p < p̄,

where R² = R0 eµ² T and p̄, λw , and λv are determined by the system of equations:
· ¸( µ ¶− γ1 )
1
−1 γ
1
p
−1 γ p − γ1 − 1
p γ a λ w a
− 1
(α0 + α1 ) γp − α0 λw p̄ γp + p̄ γa
1 − γp 1 − γa λ v
α1 w0 R² − γ1
= p̄ m , (46)
α0 + α1

“ ” ½ 1
¾
−
1−γp
µp −
1−γp 2
σp γp
−1 1
−1 − γ1
e γp 2γp
α0 [1 − A (γp )] + (α0 + α1 ) γp
A (γp ) λw p
½ 1 ¾ µ ¶− γ1
− 1−γ ( p 2γ p )−1
a µ − 1−γa σ 2
γa
1
−1 λw a
+e a γ a α0 [1 − A (γa )] + (α0 + α1 ) γa A (γa )
λv
1−γm 2 α1 w0 R²
+ e− γm (µp − 2γm σp )
1−γm
A (γm ) = w0 , (47)
α0 + α1
and
½ 1 ¾ µ ¶1− γ1
− 1−γ ( p 2γ p )
a µ − 1−γa σ 2 γa
−1 1
−1 λw a
e γ a a α0 [1 − A (γa )] + (α0 + α1 ) a A (γa )
γ
λv
= (1 − γa )v0 , (48)

where µ ¶
ln p̄ − µp 1 − γ
A(γ) = N + σp ,
σp γ
where N (·) is the cumulative distribution function of a standard normal random vari-
able.

24
 Under the first-best contracts, both pay schedule and final wealth are monotone
functions of state price. Hence there is a unique relation between pay schedule and
final wealth. This is especially useful in comparisons between the first- and second-
best contracts. Without confusion, we also call this relation the first-best contracts.
The following graphs illustrate this relations for two numerical examples.

0.035
α(w, s) = 0.02 w + 0.05 (w - w0 Rs)+
α(w, s) = 0.02 w
α(w, s) = w
0.03

0.025

0.02

0.015

0.01

0.005

0
0.5 1 1.5 2 2.5

Figure 1: First-best contracts against final wealth with the same reservation. Both
final wealth and pay schedules are normalized by the initial wealth. Preferences are
power utilities and the relative risk aversion coefficients of the principal and agent
are γp = 3 and γa = 0.3, respectively. The parameters are: σp = 0.5, µs = 10%,
σs = 30%, r = 5%. The gap in the graph represents the region of {w|fw|s (w) = 0}
caused by the covexity of α(w, s).

Figure 1 plots the first-best contracts in the case in which the principal (a fund
company or an individual investor) is more risk averse than the agent. This plot
shows that the agent takes more risk by offering a convex pay schedule. This is the
result of the optimal risk sharing between principal and agent. Intuitively, the first-
best pay schedule becomes concave if the agent is more risk averse than the principal

25
as illustrated in Figure 2.

0.009
α(w, s) = 0.02 w + 0.05 (w - w0 Rs)+
α(w, s) = 0.02 w
α(w, s) = w
0.008

0.007

0.006

0.005

0.004

0.003

0.002
0 1 2 3 4 5 6

Figure 2: First-best contracts against final wealth with the same reservation. Both
final wealth and pay schedules are normalized by the initial wealth. Preferences are
power utilities and the relative risk aversion coefficients of the principal and agent
are γp = 0.3 and γa = 3, respectively. The parameters are: σp = 0.5, µs = 10%,
σs = 30%, r = 5%. The gap in the graph represents the region of {w|fw|s (w) = 0}
caused by the covexity of α(w, s).

Although there is no incentive concern in the first-best contracts, the first-best

pay schedule may be very sensitive to the performance of a delegated portfolio. Such
sensitivities are solely due to the optimal risk sharing and becomes a constant if both
principal and agent share the same preferences. If the first-best model presented
here is a good approximation for some of the delegated portfolio management, e.g.,
existing a good proxy for the market portfolio, then different pay contracts across fund
companies are simply the results of different risk attitudes among fund companies and
managers.

26
4.3 Imperfect Signals

In practice, the market portfolio is not observable due to various reasons, hence an
index with a subset of stock is used in the contracting problem. In this case, we have
to seek the second-best solutions. Due to the numerical complexity, we only consider
a simple case in which
α(w, s) = α0 w.

By equation (41), we have

0 µ ¶
fp|s (p) 1 σp
=− ln p − ρ s − µp|s , (49)
fp|s (p) (1 − ρ2 )σp2 p σs

where s = ln Rs and µp|s = µp − ρ σσps µs − (1 − ρ2 )σp2 is a constant. Substituting this

into the ODE (27) and using p = x0 /λ yields, for each s,
· µ ¶¸
0 0 u0 [α0 − h0 x0 ] + (β − λv )x0 σp
β − 2u h − ln x − ρ s − µp|s − ln λ x00
0
(1 − ρ2 )σp2 x0 σs
2
= − u00 [α0 − h0 x0 ] + u0 h00 [x0 ]2 . (50)

Because the righthand side of the ODE is positive and x00 ≤ 0, the solution has to
satisfy the constraint
µ ¶
0 0 u0 [α0 − h0 x0 ] + (β − λv )x0 0 σp
β − 2u h − ln x − ρ s − µp|s − ln λ < 0. (51)
(1 − ρ2 )σp2 x0 σs

The second-order ODE (50) can be solved numerically by transforming it into a

system of first-order ODEs given a set of boundary conditions. Because the ODE
contains parameters that are determined endogenously, it is not obvious to choose
starting values. However, the asymptotic behavior of the ODE can be obtained by
combining it with the differential-integral equation (25).

Lemma 4 Given (λ, λw , λv ). If x is a second-best solution to the contracting problem,

then
u0 [α0 − h0 x0 ] + (β − λv ) x0 −→ 0

as w goes to ∞.

27
 This lemma sets additional constraints on the feasible solutions to the ODE. Such
constraints make the searching a numerical solution much easier.

0.03 First-best
P = 1%
P = 99%
s = -50%
s = -38%
0.025 s = -26%
s = -14%
s = -02%
s = 10%
0.02 s = 22%
s = 34%
s = 46%
s = 58%
s = 70%
0.015

0.01

0.005

0
0.5 1 1.5 2 2.5 3

Figure 3: Optimal contracts against final wealth. Both final wealth and pay schedules
are normalized by the initial wealth. Label “s” represents the second-best conditional
on returns of a benchmark portfolio and “P” represents the conditional cumulative
probability distributions of final wealth. Preferences are power utilities and the rel-
ative risk aversion coefficients of the principal and agent are γp = 3 and γa = 0.3,
respectively. The gross benefit of the principal α(w) = 0.02w. The parameters are:
σp = 0.5, µs = 10%, σs = 30%, r = 5%, and ρ = 0.8.

We present two numerical examples in the following. In the first example, the
principal is assumed to collect a 2% fee on the final wealth from the fund investors.
The model parameters are stated in the figures captions. Figure 3 plots the optimal
contracts, both the first- and second-best, against the final wealth, where the second-
best pay schedules are conditional on the returns of the benchmark index. In addition,
the cumulative distribution conditional on the benchmark returns for 1% and 99%
is also ploted in the graph. One of the striking features of the second-best contracts

28
is the flatness conditional on the benchmark returns within a reasonable range of
portfolio returns. This indicates managers will not get large rewards for dazzling
performance relative to the benchmark. However, they do get hefty rewards when
the returns of the benchmark are high even the return of the managed portfolio is
below the benchmark.

0.0022

0.00215

0.0021

0.00205

s = 9.94%
s = 10.06%
s = 10.18%
0.002 P = 1.00%
P = 99.00%
1 1.5 2 2.5 3 3.5

Figure 4: Second-best contracts against final wealth. Both final wealth and pay
schedules are normalized by the initial wealth. Label “s” represents the second-best
conditional on returns of a benchmark portfolio and “P” represents the conditional
cumulative probability distributions of final wealth. Preferences are power utilities
and the relative risk aversion coefficients of the principal and agent are γp = 3 and
γa = 0.3, respectively. The gross benefit of the principal α(w) = 0.02w. The param-
eters are: σp = 0.5, µs = 10%, σs = 30%, r = 5%, and ρ = 0.8.

Another interesting feature to notice is the similarities between the contour curves
for fixed conditional cumulative probabilities, e.g., the curve with P = 1% in Figure 3,
and the first-best pay schedule. This illustrates the role of the benchmark in designing
the second-best contracts. The benchmark makes the second-best contracts more

29
first-best like, and thses two kinds of contracts become exactly the same when the
return of benchmark is perfectly correlated with the state price. This is of course an
indication of efficiency improvement by incorporating the benchmark in designing the
second-best contracts. Such efficiency gains are also evident by the clear separations
of the conditional pay schedules. The usefulness of the benchmark is determined by
the correlation between the benchmark and state price; the conditional pay schedules
get closer with a lower correlation.

Of course the flatness of the second-best contracts is only a relative term. For
example, the pay should converge to 0 with the gross return. The plots truncate the
pay schedule to illustrate its insensitivity to returns in a reasonable range. Figure 4
further illustrates the detailed second-best contract conditional on particular levels of
the benchmark returns. It is obvious that the conditional pay schedules are concave
but the absolute variations are quite small. This is why they look very flat in Figure
3.

Figures 5 and 6 replicate the previous two plots but with different preferences and
gross benefit of the principal (e.g., a wealthy individual investor). At this time, the
principal is less risk averse. Although, as indicated by Figures 1 and 2, the shapes
of the first-best contracts are quite distinguished by the relative risk aversion be-
tween the principal and agent, the conditional second-best contracts are quite similar
in terms of flatness and concavity, especially in the reasonable range of portfolio re-
turns. All qualitative observations we have discussed for the previous case are exactly
applied here, too. The less sensitivity to the benchmark is due the less divergence of
preferences between the principal and agent.

There are two opposite forces working against each other in the second-best con-
tracting problem; one is the risk-sharing, the other is the similarity. The latter means
designing a pay schedule such that effective preferences for the agent, v(y), is similar
to the principal’s. As shown in the case of first-best contracting problem, optimal
risk-sharing is to let the less risk-averse party take more risk. However, the similarity
condition requires that the less risk-averse party taking more risk, hence the effective
preferences after splitting the gross returns are similar. These two opposite condi-

30
 0.0012
First-best
P = 01%
P = 99%
0.0011

s = 70%
0.001 s = 60%
s = 50%

0.0009 s = 40%
s = 30%
s = 20%
0.0008 s = 10%
s = 00%
s = -10%
0.0007 s = -20%
s = -30%
s = -40%
0.0006 s = -50%

0.0005
0 0.5 1 1.5 2 2.5 3 3.5

Figure 5: Optimal contracts against final wealth. Both final wealth and pay schedules
are normalized by the initial wealth. Label “s” represents the second-best conditional
on returns of a benchmark portfolio and “P” represents the conditional cumulative
probability distributions of final wealth. Preferences are power utilities and the rel-
ative risk aversion coefficients of the principal and agent are γp = 1.5 and γa = 3,
respectively. The gross benefit of the principal α(w) = w. The parameters are:
σp = 0.5, µs = 10%, σs = 30%, r = 5%, and ρ = 0.8.

tions make the second-best contracts flat, especially in comparison to the first-best
contracts. This qualitative feature of the second-best contracts also holds for the ones
without any signals. As shown in Li and Zhou (2005), the flatness is also prevalent in
the case in which the state price follows a uniform distribution, and it also depends
on the level of reservation, which affects the relative strength between risk-sharing
and preference similarity.

Although the second-best contracts are concave in the reasonable range of portfolio
returns for the two examples, we cannot conclude that they are always concave,
especially for extreme returns. Again, as shown in Li and Zhou (2005), the second-

31
 0.00079242

0.00079241

0.0007924

0.00079239

0.00079238

0.00079237 s = 10%
P = 1%
P = 99%
0 1 2 3 4 5 6 7 8

Figure 6: Second-best contracts against final wealth. Both final wealth and pay
schedules are normalized by the initial wealth. Label “s” represents the second-best
conditional on returns of a benchmark portfolio and “P” represents the conditional
cumulative probability distributions of final wealth. Preferences are power utilities
and the relative risk coefficients of the principal and agent are γp = 1.5 and γa = 3,
respectively. The gross benefit of the principal α(w) = w. The parameters are:
σp = 0.5, µs = 10%, σs = 30%, r = 5%, and ρ = 0.8.

best contracts can be a combination of locally concave and convex curves. A more
detailed study of the second-best contracts is interesting. However, such an inquiry,
which calls for a rigorous analytical treatment of the ODE and a tailor-made numerical
method, is outside the scope of this paper.

As a final note, we notice that the shape of the second-best contract in the clas-
sical principal-agent models with moral hazard is steeper than that of the first-best
contract. This is consistent with our intuition, since the principal needs to motivate
the agent to exert a high effort. In contrast, the shape of the second-best contract in
our context is flatter than that of the first-best contract, as the investor does not have

32
to motivate a high manager’s effort. This different prediction of the optimal contract
shows the key difference between the model with effort and the model with choice.

5 Conclusion

The stock indexes are created for many different purposes. In this paper we show
that one of their side effects is socially valuable, that is, they can help to reduce, or
eliminate when properly constructed, agency costs when the fund manger’s portfolio
choice cannot be contracted upon. The condition for a stock index to achieve the
first-best risk sharing is strikingly simple: it only needs to be a market portfolio,
which is by definition perfectly correlated with the state price. In this situation, the
fund’s total return plus the benchmark return can implement the first-best contract.
In general, however, the market portfolio may not be observable. Then, a close
substitute, e.g., a stock index, can be used in the contract design. In this case the
magnitude of efficiency improvement depends on how close the stock index is to the
market portfolio.

The next natural step to enrich our model would be to introduce the fund man-
ager’s private information or other information structures into the analysis. Doing so
would shed light on the nature of contracts for the managers of “actively” managed
funds, which would be a complement to what we have done in this paper. This is
a largely unexplored area. As mentioned earlier, Stoughton (1993), and Admati and
Pfleiderer (1997) point out some problems of the popular linear contract and bench-
marks in the presence of private information. However, their conclusion is based on
a given class of compensation schemes. The true role of benchmarks in the design of
optimal compensation schemes in this rich environment is still not well understood,
and a lot of work is left to be done along this line.

33
Appendix: Proofs

Proof of Lemma 1

See Lemma 1 in Li and Zhou (2005).

Proof of Lemma 2

We need the following result first to proceed the proof. This result is also used in
solving the contracting problems later.

Lemma A.1 For any given distribution function fw|s , let E ² [pw] be the present value
²
of the wealth under a perturbed density function fw|s = fw|s + ²η, where ² is a constant
R
and η satisfies η(t, s) dt = 0. Then,
Z Z ∞ ·Z w ¸
dE ² [pw] −1
= ds fs (s) η(w, s) Fp|s (1 − Fw|s (t)) dt dw
d² 0 `

and
Z Z ∞ µZ w ¶2
d2 E ² [pw] 1
= ds fs (s) −1 ²
η(t, s) dt dw,
d²2 0 fp|s (Fp|s (1 − Fw|s (w))) 0

−1
where ` is an arbitrary number such that fw|s (`) > 0 or `Fp|s (1 − Fw|s (`)) is finite.

Proof. Perturb the density function fw|s by ²η(w, s), where ² is a small constant and
η(w, s) is an arbitrary piece wise smooth function that satisfies
Z ∞
η(w, s) dw = 0.
0
²
Let Fw|s denote the cumulative distribution function conditional on the signal s. Note
that
Z w Z ∞
²
1− Fw|s (w) =1− [fw|s (t) + ²η(t, s)] dt = [fw|s (t) + ²η(t, s)] dt.
0 w

Let Z ∞
s,² ² −1 ²
E [w] = fw|s (w)Fp|s (1 − Fw|s (w))w dw.
0

34
Then, the first derivative of the perturbed expected wealth is
Z ∞ Z ∞ ² Z
dE s,² [w] −1 ²
wfw|s (w) w
= η(w, s)wFp|s (1 − Fw|s (w)) dw − η(t, s)dt dw.
d² 0 0 fp|s 0

Applying the integration by parts to the second integral of the right hand side yields
Z ∞ ² Z
wfw|s (w) w
η(t)dt dw
0 fp|s 0
Z w ² Z w ¯∞ Z Z w ²
tfw|s (t) ¯ ∞ tfw|s (t)
¯
= dt η(t) dt¯ − η(w) dt dw
` fp 0 ¯ 0 ` fp|s
0
Z ∞ ·
−1 ² −1 ²
= η(w) wFp|s (1 − Fw|s (w)) − `Fp|s (1 − Fw|s (`))
0
Z w ¸
−1 ²
− Fp|s (1 − Fw|s (t)) dt dw,
`

where ` is a positive number. This shows that

Z ∞ ·Z w ¸
dE s,² [w] −1 ²
= η(w) Fp|s (1 − Fw|s (t)) dt dw.
d² 0 `

Then, taking derivatives to the above equation again and integrating by parts shows
that
Z ∞ · Z w Z t Z ` ¸
d2 E s,² [w] 1 `
= η(w, s) − η(a, s) da dt − η(a, s) da dw
d²2 0 ` fp|s 0 fp|s 0
Z ∞ µZ w ¶2
1
= −1 ²
η(t, s) dt dw,
0 fp|s (Fp|s (1 − Fw|s (w))) 0

where the term with ` equals zero. Finally, the relation between E ² and E s,² leads to
the lemma. ¤

Let x(w, s) = v(y(w, s)). To maximize the Lagrangian given by (15) is to maximize
the following:
Z ∞ µZ ∞ ¶
s −1
V = x(w, s)fw|s (w) dw − λ fw|s (w)[Fp|s (1 − Fw|s (w))]w dw − w0
0 0
Z ∞
+ λf (w, s)fw|s (w) dw,
0

where λ is a positive constant and λf (w, s) is a nonnegative function, which equals

zero when fw|s > 0 and is nonnegative when fw|s = 0. Then, following the proce-
²
dure as described in the proof of Lemma 1, let fw|s (w) = fw|s (w) + ²η(w, s), where

35
R∞
0
η(w, s) dw = 0 and fw|s is the optimal solution. Then, define the perturbed La-
grangian as
Z ∞
s,² ²
V = [x(w, s) + λf (w, s)] fw|s (w) dw
0
µZ ∞ ¶
² −1 ²
−λ fw|s (w)[Fp|s (1 − Fw|s (w))]w dw .
0

Using Lemma 1, the first two derivatives of the Lagrangian with respect to ² are
Z ∞ ·
dV s,²
= η(w, s) x(w, s) + λf (w, s)
d² 0
µZ w ¶¸
−1 ² −1 ²
− λ Fp|s (1 − Fw|s (t)) dt + `Fp|s (1 − Fw|s (`)) dw,
`

and Z µZ ¶2
∞ w
d2 V s,² 1
= −λ −1 ²
η(t, s) dt dw < 0.
d²2 0 fp|s (Fp|s (1 − Fw|s (t))) 0

This shows that the Lagrangian V s always has an interior maximum and the first-
dV s,²
order condition d² ²=0
| = 0 is both sufficient and necessary when we restrict fw|s ≥ 0.
Yet this is true if and only if there exists a function c(s) which does not depend on
w, such that
Z w
−1 −1
x(w, s) − λ Fp|s (1 − Fw|s (t)) dt − λ`Fp|s (1 − Fw|s (`)) + λf (w, s) ≡ c(s) (52)
`

holds almost everywhere. As x is bounded above by v(α(w, s)), there exists a function
Fw|s or fw|s such that equation (52) holds.

This equality and Lemma 1 imply that

x(`, s) − λ`Fp−1 (1 − Fw (`)) = c(s)

for all ` ∈ {t|∞ > fw|s (t) > 0}.

Let λ` (s) = x(`, s) and define

Z w
−1
x̃(w, s) = λ Fp|s (1 − Fw|s (t)) dt + λ` (s).
`

As x(w, s) ≤ x̃(w, s) and x̃(w, s) is nondecreasing and concave, x̃(w, s) is the smallest
concavification of x(w, s) for each s. Otherwise, it contradicts the first-order condi-
tion.

36
Proof of Proposition 1

The first-order derivatives of U with respect to λ and λ` are straightforward by noting

that Z w
−1
x(w, s) = λ Fp|s (1 − Fw|s (t)) dt + λ` (s).
`
Then the second order derivatives are given by
Z Z ∞
∂ 2U 1 0 0
2 ∂[u h ]
= − ds f s (s) f w|s (w)[x(w, s) − λ ` (s)] dw < 0;
∂λ2 λ2 0 ∂x
Z Z ∞
∂ 2U 1 ∂[u0 h0 ]
= − ds fs (s) fw|s (w)[x(w, s) − λ` (s)] dw;
∂λdλ` (s) λ 0 ∂x
Z Z ∞
∂2U ∂[u0 h0 ]
= − ds fs (s) fw|s (w) dw < 0,
∂λ2` (s) 0 ∂x

where the negativeness of the second derivatives is due to the fact that
∂[u0 h0 ]
= −u00 [h0 ]2 + u0 h00 > 0,
∂x
because both u and v are concave functions. A direct calculation shows
· ¸2
∂ 2U ∂2U ∂2U
− > 0.
∂λ2 ∂λ2` ∂λ∂λ` (s)
Since this holds for any (λ, λ` (s)), the solution to the first-order condition maximizes
the objective globally and is unique.

Proof of Proposition 2

Let U s,² denote the perturbed U s , that is

Z ∞
s,²
U = [u + λv x² + λf (w)]fw|s
²
dw − λw E s,² [pw] + λw w0 − λv v0 .
0

Then the first-order derivative of U ² is

Z ∞
dU s,²
= η(w, s)[u + λv x² + λf (w)] dw
d² 0
Z ∞ ²
² d[u + λv x ] dE s,² [pw]
+ fw|s dw − λw . (53)
0 d² d²

37
First note that, using (18) or Lemma 2, we have
Z w Z t
dx² (w) 1
= −λ η(a, s) da dt.
d² ` fp|s 0

Then,
Z ∞ Z ∞
² + λ v x² ]
d[u ²
² dx (w)
fw|s (w) dw = − [u0 h0 − λv ]fw|s dw
0 d² 0 d²
Z ∞ ·Z w Z t ¸
0 0 ² 1
= λ [u h − λv ]fw|s (w) η(a, s) da dt dw,
0 ` fp|s 0

where we use the fact that the derivatives of λ² and λ²` do not depend on w. Note that
the last two terms are equal to zero due to the first-order conditions in Proposition
1. Therefore, integration by parts shows
Z ∞
² d[u + λv x² ]
fw|s (w) dw
0 d²
Z ∞ ·Z w Z t ¸
0 0 ² 1
= λ [u h − λv ]fw|s (w) η(a, s) da dt dw
0 ` fp|s 0
Z w Z w Z t ¯∞
1 ¯
= λ ² 0 0 ²
[u h − λv ]fw|s (t) dt η(a, s) da dt¯¯
0 ` fp|s 0 0
Z ∞ Z w ·Z w ¸
1 0 0 ²
−λ η(t, s) dt [u h − λv ]fw|s dt dw
0 fp|s 0 0
Z ∞ Z w ·Z t ¸
1 0 0 ²
= λ η(w, s) [u h − λv ]fw|s da dt dw,
0 0 fp|s 0

where we have use the first-order condition for λ` , equation (23). Using this equation
and Lemma 1, the first derivative of U ² with respect to ² is:
Z ∞ · Z w Z t ¸
dU s,² ² 1 0 0 ²
= η(w, s) u + λv x + λf + λ [u h − λv ]fw|s da dt dw
d² 0 0 fp|s 0
Z ∞ ·Z w ¸
−1 ²
− λw η(w, s) Fp|s (1 − Fw|s (t)) dt dw, (54)
0 `

38
where we have used Lemma 1. However, when ² = 0, we have x² = x and
¯ Z ∞ · Z w Z t ¸
dU s,² ¯¯ 1 0 0
= η(w, s) u + λv x + λf + λ [u h − λv ]fw|s da dt dw
d² ¯²=0 0 ` fp|s 0
Z ∞ ·Z w ¸
−1
− λw η(w, s) Fp|s (1 − Fw|s (t)) dt dw
0 `
Z ∞ ·
= η(w, s) u + λv x + λf
0
· Z w Z t ¸
1 0 0 λw λw
+ λ [u h − λv ]fw|s da dt − x+ λ` dw = 0,
` fp|s 0 λ λ

where the second last equality is obtained by using the constraints (18) or Lemma 2.
The above integral equals zero for any arbitrary η such that
Z ∞
η(w, s) dw = 0
0

if and only if there exists a c(s) that is independent of w such that

λw
u(α(w, s) − h(x(w, s))) + λv x(w, s) − x(w, s) + λf (w, s)
Z w Z t λ
1
+λ [u0 h0 − λv ]fw|s (a) da dt = c(s) (55)
` fp|s 0

holds almost everywhere, where we ignore the constant terms. Specifically, we have
· ¸
λw
u(α(w, s) − h(x(w, s))) + λv − x(w, s)
λ
Z w Z t
1
+λ [u0 h0 − λv ]fw|s (a) da dt = c(s)
` fp|s 0

when fw|s (w) > 0.

Proof of Proposition 3

The derivation of the second-order ODE is straightforward. See Li and Zhou (2005)
for the other results.

39
Proof of Lemma 3

Let F (w, y|s) is the joint cumulative distribution function for given w(ω) ∈ A and
y(ω) conditional on the signal s, we then have
Z
u(α(w(ω), s) − y(ω)) P (dω)
Ω Z Z
= ds fs (s) u(α(w(ω), s) − y(ω)) P (dω|s)
Z ZΩ
= ds fs (s) u(α(w, s) − y) dF (w, y|s)
Z Z Z
= ds fs (s) dFw|s (w) u(α(w, s) − y) dF (w, y|s, w)
Z Z
≤ ds fs (s) u(α(w, s)) − E[y|s, w]) dFw|s (w).

The last inequality is due to Jensen’s inequality and becomes equality if

y(ω) = y(w, s) for all ω ∈ {ω 0 |(w(ω 0 ) = w, s(ω 0 ) = s}.

This means the optimal pay takes the form of y(w, s).

Proof of Proposition 4

Because x or (y(w)) is a free choice function, the maximization problem is quite

straightforward. It is similar to the case of agent’s problem for fw . The second order
is automatically satisfied by the budget constraint. And for the case of x, the second
order is due to that fact that u(α(w) − h(x)) is a concave function of x for any fixed
w. We skip the details of the calculations.

Proof of Corollary 1

If λf (w, s) = 0, fw|s > 0. Then the two first-order conditions in Proposition 4 become

u0 α0 = λw p and u0 = λv v 0 . (56)

40
Then it is straightforward to check that these two equations imply the pay schedule
and the final wealth in the corollary.

Having recognized that u + λv x is concave in w if the condition is satisfied, the

second part follows immediately.

Proof of Theorem 1

It is trivial to examine the contracting problems or the first-order conditions. If fp|s

is singular at s, then fw|s (w) is also singular. Therefore, the first-order conditions
(22) and (23) hold only if u0 h0 = λv , then the third first-order condition (24) becomes
equation (35) in light of equation (18).

Proof of Corollary 2

By Proposition 4, for any w ∈

/ (wl , wh ), where wl and wh satisfy equations (44), we
have u0 α0 = λw p and u0 = λv v 0 . Substituting these equation into equations (16) leads
to
u(α(wh , s) − y(wh , s)) + λv v(y(wh , s)) − u(α(wl , s) − y(wl , s)) − λv v(y(wl , s))
wh − wl
= λw p, (57)

where s = Rs is as defined by equation (43). Also, by Corollary 1, we have the pay

schedule as given by
 ³ ´− γ1

 λw p a
λv α0
if w ≤ wl
y(w(p), s(p)) = ³ ´− γ1

 λw p a
λv (α0 +α1 )
if w ≥ wh

and the final wealth is given by

 ·³ ´ 1 ³ ´− γ1 ¸
−γ

 1 λw p p λw p a
 α0 α0
+ λv α 0 if w ≤ wl
w(p) = ·³ ´− γ1 ³ ´− γ1 ¸

 1 λw p p − γ1 λw p a
 α0 +α 1 α0 +α1
+ α1 w 0 R ² p m +
λv (α0 +α1 )
if w ≥ wh .

41
Then, substituting these into (57) yields equation (46).

Given p̄, the pay schedule and final wealth can be rewritten as in the the theorem.
Then, the budget constraint is
Z p̄ Z ∞
w(p)pfp (p) dp + w(p)pfp (p) dp = w0 .
0 p̄

Using the identities, for any γ,

Z p̄ Z ln p̄
−γ 1 − 12 (x−µp )2
p fp (p) dp = √ e−γx e 2σp dx
0 2πσp −∞
· µ ¶¸ µ ¶
γσp2 ln p̄ − µp + γσp2
= exp −γ µp − N ,
2 σp
and
Z · µ ¶¸ · µ ¶¸
∞
−γ
γσp2 ln p̄ − µp + γσp2
p fp (p) dp = exp −γ µp − 1−N
p̄ 2 σp
gives us equation (47). Similarly, equation (48) is also obtained from the participation
constraint.

Proof of Lemma 4
Rw
Since both fp|s and 0
[u0 h0 − λv ]fw|s (t) dt converge to 0 as w goes to ∞, L’Hopital’s
rule implies
Z w
λ λfp|s (p)
[u0 h0 − λv ]fw|s (t) dt → −[u0 h0 − λv ] 0
fp|s (p) 0 fp|s (p)
as w goes to ∞. Then, equation (25) shows
λfp|s (p)
u0 [α0 − h0 x0 ] + (β − λv )x0 → [u0 h0 − λv ] 0
.
fp|s (p)
Suppose this converges to a constant b. That is
λfp|s (p)
u0 [α0 − h0 x0 ] + (β − λv )x0 → [u0 h0 − λv ] 0
→ b. (58)
fp|s (p)
λfp|s (p)
As w goes to ∞, x0 = λp converges to 0 and 0 (p)
fp|s
converges to 0. In this case, at
fp|s (p)
best, u0 h0 ∼ 1
p
by equation (58) and 0 (p)
fp|s
∼ − lnpp , hence b has to equal 0.

42
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