Providing Managerial Incentives: Do Benchmarks Matter?∗

In this paper we revisit the question of whether relative performance-adjusted contracts provide portfolio managers with adequate incentives to gather information. We show that when portfolio managers are constrained in their ability to short-sell, relative performance-adjusted or linear ‘benchmarked’ contracts can provide incentives for gathering more precise information. We also provide conditions under which they emerge as optimal linear contracts contracts. We show that when borrowing constraints are present, the risk-averse manager’s optimal effort is, under certain conditions, an increasing function of her share on the portfolio’s return. In addition, the optimal contract offered by the risk-neutral client to the risk-neutral, short-selling constrained manager is shown to be a benchmarked contract for any value of the constraint. In the limit, as short-selling constraints are relaxed, the optimal contract is first-best. ∗Preliminary. Please do not quote. —Address all correspondence to Juan-Pedro Gómez, Centro de Investigación Económica (ITAM) Ave. Santa Teresa 930 Mexico City 10700. Phone:(525) 6284197. Fax: (525) 628-4058. †Centro de Investigación Económica, ITAM and Universidad Carlos III. E-mail: [email protected] ‡Centro de Investigación Económica, ITAM. E-mail: [email protected]