Mutual Fund Portfolio
Constraints: Carrying Coals to Newcastle?
Professor of Finance, Washington University in St. Louis
Investors often impose shortsale and
no-leverage constraints on many mutual funds. However, we rarely observe these
constraints bind in the portfolios of these funds. Are investors carrying
coals to Newcastle? In a principle-agent optimal contracting framework in which
risk-averse agents (managers) are protected by limited liability, we find that
such constraints are necessary to curb managers’ excessive risk-taking as a
result of limited liability. These constraints do not appear binding because
there is an interior portfolio weight (between 0 and 1) that is locally
optimal, and the constraints transform it to become a constrained global
optimum. Moreover, this “non-binding puzzle” is exclusive for “low-type”
managers, which suggests a new indicator of investment skill.