Rewarding Trading Skills Without Inducing Gambling

Abstract

This paper develops a model of active portfolio management in which fund managers may secretly gamble in order to manipulate their reputation and attract more funds. We show that such trading strategies may expose investors to severe losses and are more likely to occur when fund managers are impatient, their trading skills are scalable and generate a high profit per unit of risk. We study long-term contracts that deter this behavior. We show that contracts that simultaneously increase and defer the manager's expected fee after abnormally high returns eliminate risk-shifting incentives and implement the first-best.