The Quality-Assuring Role of Mutual Fund Advisory Fees

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: excessive fees, advisory fees, quality-assurance, open-access, closet indexing

JEL Classification: D23, D86, G23, L22