DP4038 Relative Performance Evaluation Contracts and Asset Market Equilibrium

Author(s): Sandeep Kapur , Allan G Timmermann

Publication Date: September 2003

Keyword(s): portfolio delegation , relative performance evaluation , equity premium

JEL(s): G11 , G12 , G23

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP4038.asp

We analyse the equilibrium consequences of performance-based contracts for fund managers. Managerial remuneration is tied to a fund's absolute performance and its performance relative to rival funds. Investors choose whether or not to delegate their investment to better-informed fund managers; if they delegate they choose the parameters of the optimal contract subject to the fund manager's participation constraint. We find that the impact of relative performance evaluation on equilibrium equity premium and on portfolio-herding critically depends on whether the participation constraint is binding. Simple numerical examples suggest that the increased importance of delegation and performance evaluation may lower the equity premium.