As information is not transparent, it leads to conflict of interest between investors and fund managers. Investors cannot observe at any cost to all acts of fund managers, especially in distribution of income which is not observed from Fund investment portfolio. This would allow a fund manager to select funds beneficial to own interests to maximize the portfolio, rather than first considering the largest of the interests of investors. Therefore, a large amount of literature focuses on how to set up a valid contract to maximize ease of agency conflicts between fund managers and investors.
Holmstorm (1982) was the first to propose explicit incentive mechanism problem. He used the principal-agent theory model to show that if the principal cannot observe the agent’s action in order to induce the agent by the principal of the maximum desired operations, the principal must be based on the observable results to incentive agent. Such incentives are called explicit incentive mechanism. In the asset management industry, reward contract constitutes coordination investors and fund managers conflicts of interest to explicit incentive contract.
On the investment fund system, the explicit incentive contract includes fund managers’ compensation and compensation stipulated in the contract, fund management fees and incentive fees. Incentive fees are divided into the same intensity of punishment symmetrical performance fees and only be awarded for outstanding performance, while poor performance results in impunity of asymmetric performance fees.
Modigliani and Pogue (1975) from the CAPM, pointed out to the market index as an evaluation criterion, the symmetrical incentive contract will encourage fund managers choose the high level of risk. Starks and Laura (1987) response to this problem, from the principal-agent theory, proposed incentive contract design requires a remuneration mechanism consists of risk-sharing guidelines. The risk-sharing guidelines allocated in exogenous risk of fluctuations in investment performance between the principal and the agent. Starks and Laura further concluded that by establishing fund managers incentive model based on a risk prediction. According to the net assets, there is extracted a certain percentage of the fund management fee which enables managers to make greater efforts, but the fund managers will also choose a larger than investors expected level of risk. Compared with asymmetric incentive contract and optimal symmetrical performance contract, many more incentives lead to fund managers choosing level of risk and the level of effort consistent with the wishes of the principal. The agent can be bound by the investment behaviour more in line with the interests of investors. Asymmetric contracts will induce fund managers to take the risk of investment behaviour. Eichberger et al. (1994) think that based on the relative performance of incentive plan, the investors can control the fund manager’s activity in an effective incentive manner.