The Impact of Benchmarking and Portfolio Constraints on a Fund Manager's Market Timing Ability

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Abstract
We study the effects that relative (to a benchmark) performance evaluation has on the provision of incentives for the search of private information when managers are exogenously constrained in their ability to sell short and purchase on margin. With these portfolio constraints we show that benchmarking the manager's incentive fee affect her timing ability and hence there exist an optimal benchmark, even without moral hazard between the investor and manager. In the presence of moral hazard, numerical results show that the optimal incentive fee is higher than the Pareto-efficient fee and the optimal benchmark is risky but less so than the no moral hazard benchmark.

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