Portfolio delegation under short-selling constraints

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. We find that the risk-averse manager’s effort is an increasing function of her share in the portfolio’s return. This result affects the risk-averse investor’s choice of contracts. Unlike previous results, the purely risk-sharing contract is now shown to be suboptimal. Using numerical methods we show that under the optimal linear contract, the manager’s share in the portfolio return is higher than what it is under a purely risk sharing contract. Additionally, this deviation is shown to be: (i) increasing in the manager’s risk aversion and (ii) larger for tighter short-selling restrictions. As the constraint is relaxed the deviation converges to zero.