Working Paper: CEPR ID: DP10438
Authors: Michel Antoine Habib; D. Bruce Johnsen
Abstract: Active fund managers implicitly promise to research profitable portfolio selection. But active management is an experience good subject to moral hazard. Investors cannot tell high from low quality up front and therefore fear manager shirking. We show how the parties mitigate the moral hazard by paying the manager a premium fee sufficiently high that the manager's one-time gain from shirking is less than the capitalized value of the premium stream he earns from maintaining his promise to provide high quality. Premium advisory fees act as a quality-assuring bond. Our model has a number of revealing extensions and comparative statics.
Keywords: advisory fees; closet indexing; excessive fees; quality assurance
JEL Codes: D23; D86; G23; L22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher premium fees (G22) | deter manager shirking (M54) |
| premium fee exceeds marginal research costs (D40) | diminished incentive to shirk (H31) |
| capitalized value of future compensation (J17) | disincentive for shirking (J33) |
| ability of institutional investors to monitor managers (G34) | lower fees than retail investors (G19) |
| threat of losing capitalized value of premium fees (G32) | incentive for managers to deliver quality performance (M52) |
| mutual fund structure (G23) | high-powered incentives for managers to perform research (M52) |