Information Asymmetry and Incentives for Active Management

Abstract:     
This paper presents a model in which fund managers choose between active management and passive management when investors cannot directly observe managers' efforts and skills. In an equilibrium skilled managers actively manage their funds only when skills can add a large value in active management. If active management is not sufficiently valuable, the surpluses of investors and managers are higher when all managers track market indexes. As a result, a pooling equilibrium arises. More competition from other investment vehicles can also lead to a pooling equilibrium. The model suggests that a growth in passive management (e.g., closet-indexing) in the mutual fund industry can be a consequence of the dynamic environment of the money management industries and is in fact an efficient outcome.

Number of Pages in PDF File: 51

Keywords: delegated portfolio management, incomplete information, mechanism design, incentive compensation

JEL Classification: C72, C78, D70, G20

working papers series