Carrot and Stick: A Risk-Sharing Rationale for Fulcrum Fees in Active Fund Management

52 Pages Posted: 26 Sep 2016 Last revised: 12 Dec 2020

See all articles by Juan M. Sotes-Paladino

Juan M. Sotes-Paladino

Universidad de los Andes, Chile

Fernando Zapatero

Questrom School of Business, Boston University

Date Written: December 11, 2020

Abstract

We show that risk-sharing considerations rationalize symmetric benchmark-adjusted (''fulcrum'') fees in the compensation of privately informed active fund management. By tying fees symmetrically to the appropriate benchmark, investors can tilt a fund portfolio toward their optimal risk exposure and realize almost the full value of the manager's information. Since fulcrum fees do not alter the manager's preferred payoff profile, the optimal contract saves the cost of compensating the managers for exposure to undesired risk and attains near-first-best risk sharing. Under certain conditions, fulcrum fees are not only optimal but necessary to avoid a dominance of active management by passive alternatives.

Keywords: Portfolio delegation, benchmarking, fulcrum fees, asymmetric information, passive management

JEL Classification: D82, G11, G23

Suggested Citation

Sotes-Paladino, Juan M. and Zapatero, Fernando, Carrot and Stick: A Risk-Sharing Rationale for Fulcrum Fees in Active Fund Management (December 11, 2020). Available at SSRN: https://ssrn.com/abstract=2143838 or http://dx.doi.org/10.2139/ssrn.2143838

Juan M. Sotes-Paladino (Contact Author)

Universidad de los Andes, Chile ( email )

Chile

Fernando Zapatero

Questrom School of Business, Boston University ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States
617-353-3631 (Phone)

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