Underperformance fees and manager’s portfolio risk taking

This paper investigates how a manager’s compensation contract where good performance are rewarded and poor performance are penalized impacts on the managerial risk taking propensity. The results of the model indicates that the presence of underperformance penalty has a strong impact on the manager’s investment strategies. As the asset value goes to zero, the optimal proportional portfolio goes to infinity. On the other hand, as the asset value goes to infinity, the optimal proportional portfolio converges to the Merton constant, that is the portfolio the manager chooses if he were trading his own account. In some situations, the manager’s optimal portfolio is below the Merton constant. If the asset value is somewhat below the overperformance region, the manager chooses trading strategies more risky than the Merton constant. Thus, in order to assure that his incentive option will finish in-the-money, the manager increases the investment volatility, but not in the indiscriminate manner as he does in case of absence of underperformance penalty.