Brokerage Commissions, Perquisites, and Delegated Portfolio Management

Abstract

I use a three-agent setting to capture realistic features of the money management industry and highlight the importance of frictions in asset transactions. I model the price-setting process of profit-maximizing brokers, who may return portions of commissions to money managers as perquisites. A concave contract in payoffs corrects the distortions created by brokers, but compromises managers' incentive to gather information. In equilibrium, investors balance trading costs and information acquisition by offering managers roughly linear contracts, causing managers to trade excessively. Investors are better off the less competitive the brokerage industry, even when brokers bundle valuable research services at low personal costs. These findings are consistent with many well-known facts such as high levels of institutional trading and the underperformance of actively managed funds, and generate important policy implications.

Keywords: brokerage commissions, mutual funds, delegated portfolio management

JEL Classification: G24, G28