Rewarding Trading Skills Without Inducing Gambling

35 Pages Posted: 17 Mar 2010 Last revised: 20 May 2011

Igor Makarov

London Business School

Guillaume Plantin

University of Toulouse 1 - Toulouse School of Economics (TSE)

Date Written: April 2011

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.

Suggested Citation

Makarov, Igor and Plantin, Guillaume, Rewarding Trading Skills Without Inducing Gambling (April 2011). AFA 2011 Denver Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1571545 or http://dx.doi.org/10.2139/ssrn.1571545

Igor Makarov (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
+44 (0)20 7000 8265 (Phone)
+44 (0)20 7000 8201 (Fax)

Guillaume Plantin

University of Toulouse 1 - Toulouse School of Economics (TSE) ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France

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