PORTFOLIO CHOICE WHEN MANAGERS CONTROL RETURNS
This paper investigates the allocation decision of an investor with
two projects. Separate managers
control the mean return from each project, and the investor may or may
not observe the
managers’ actions. We show that the investor’s risk-return
trade-off may be radically different
from a standard portfolio choice setting, even if managers’ actions
are observable and enforceable.
In particular, feedback effects working through optimal contracts and
effort levels imply that expected terminal wealth is nonlinear
in initial wealth allocation. The optimal portfolio may involve
very little diversification, despite projects that are highly symmetric
in the underlying model. We also show that moral hazard in one
of the projects need not imply lower allocation to that project.
Expected returns are generally lower than under the first-best, but the
optimal contract shifts more of the idiosyncratic risk in the
hidden action project to the manager in charge of it. The minimum-variance
position of the investor’s (net) terminal
wealth would in most cases involve a portfolio shift towards the
hidden action project, and there are plausible cases where this would
dominate the overall effect on the second-best optimal portfolio when
comparing with the first-best.