Does It All Add Up? Benchmarks and the Compensation of Active Portfolio Managers

In this article we examine theoretically the use of benchmark portfolios in the compensation of privately informed portfolio managers. We find that the use of a benchmark, and particularly the types of benchmarks often observed in practice, cannot be easily rationalized. Specifically, commonly used benchmark‐adjusted compensation schemes are generally inconsistent with optimal risk‐sharing and do not lead to the choice of an optimal portfolio for the investor. Moreover, benchmarks do not help in solving potential contracting |problems such as inducing the manager to expend effort or trying to screen out uninformed managers.