Portfolio Delegation under Short-selling Constraints

Abstract

In this paper we study delegated portfolio management when the manager's ability to short-sell is restricted. Contrary to previous results, we show that under moral hazard, linear performance-adjusted contracts do provide portfolio managers with incentives to gather information. The risk-averse manager's optimal effort is an increasing function of her share in the portfolio's return. This result affects the risk-averse investor's optimal contract decision. The first best, purely risk-sharing contract is proved to be suboptimal. Using numerical methods we show that the manager's share in the portfolio return is higher than the rst best share. Additionally, this deviation is shown to be: (i) increasing in the manager's risk aversion and (ii) larger for tighter short-selling restrictions. When the constraint is relaxed the optimal contract converges towards the first best risk sharing contract.