Relative Portfolio Performance Evaluation and Incentive Structure

Recent literature on mutual fund performance evaluation has improved on methodologies, especially on benchmark problems pointed out by Roll (1990). However, mutual fund managers are the agents of investors, and their efforts to improve their fund performance are influenced by either explicit or implicit incentive structures within mutual fund organizations. An efficient fund evaluation should control for organizational elements that affect managerial incentives in evaluating their performance. This paper proposes an incentive-compatible portfolio performance evaluation measure. This new performance is derived from a principal-agent economics model, where managers are to maximize investors' gross returns net of managerial compensation. I consider the effect of organizational elements such as economies of scale on incentive and thus on performance. Finally, I compare this new measure with the Sharpe ratio.