Moral Hazard in Mutual Fund Management: The Quality-Assuring Role of Fees

Michel A. Habib

University of Zurich; Swiss Finance Institute

D. Bruce Johnsen

George Mason University - School of Law; PERC - Property and Environment Research Center

July 16, 2012

George Mason Law & Economics Research Paper No. 12-64

We model the role of fees in assuring the quality of active mutual fund management. Active management is an experience good subject to moral hazard; investors cannot tell high quality from low quality until after the fact. An active manager might promise to incur costly effort researching profitable portfolio selection in exchange for a fee sufficient to compensate for his higher research costs. If investors were to find this promise credible, they would buy shares until their expected returns, net of fees, just equaled investing in, say, the market index. The manager might then shirk by forgoing costly research ('closet index') and pocket the excess fee, leaving investors worse off than if they had simply invested in the index. We model this moral hazard and show how it can be mitigated by paying the manager a premium fee sufficiently high that the one-time gain from shirking is less than the capitalized value of the premium stream the manager earns from maintaining his promise to provide high quality. Investors benefit from higher fees, rather than lower fees, which act as a 'quality assuring bond,' or 'efficiency wage.' Where quality is unobservable, any attempt to impose binding maximum fees will make investors worse off. Our model has a number of revealing extensions and comparative statics.

Number of Pages in PDF File: 40

Keywords: Akerlof, asset-based fee structure, Burton Malkiel, conflict, contracts, financial economists, indexing, inflows, innovation, interest, Jonathan Berk, Klein, Leffler, Mark Carhart, regulators, retail, Ricardian rents, Richard Green, scale economies, securities, social surplus, Yellen, Yoram Barzel

JEL Classification: D61, E44, O16

working papers series

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Date posted: September 30, 2012  

Suggested Citation

Habib, Michel A. and Johnsen, D. Bruce, Moral Hazard in Mutual Fund Management: The Quality-Assuring Role of Fees (July 16, 2012). George Mason Law & Economics Research Paper No. 12-64. Available at SSRN: http://ssrn.com/abstract=2154275 or http://dx.doi.org/10.2139/ssrn.2154275

Contact Information

Michel A. Habib
University of Zurich ( email )
Plattenstrasse 14
Zurich, 8032
41-44-634-2507 (Phone)
41-44-634-4903 (Fax)
HOME PAGE: http://www.isb.uzh.ch/institut/profs/mhabib.htm
Swiss Finance Institute ( email )
c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900

D. Bruce Johnsen (Contact Author)
George Mason University - School of Law ( email )
3301 Fairfax Drive
Arlington, VA 22201
United States
703-993-8066 (Phone)
703-993-8088 (Fax)
PERC - Property and Environment Research Center
2048 Analysis Drive
Suite A
Bozeman, MT 59718
United States

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