Convex Incentives and Liquidity Premia
73 Pages Posted: 21 Dec 2018 Last revised: 11 Dec 2019
Date Written: December 12, 2019
In the mutual fund industry, managerial contracts are typically incomplete and asymmetric due to convex flows and bonuses. This gives fund managers an incentive to gamble in response to beating their benchmarks. In the presence of transaction costs, gambling is expensive and less effective at capturing flows and bonuses. As marginal investors, fund managers should then demand high expected stock returns to compensate for the direct and indirect effects of trading costs. We provide empirical support for our theory using the mutual fund scandal of 2003 as an exogenous shock to gambling incentives to identify causal effects.
Keywords: Mutual Funds, Convex Flows, Bonuses, Transaction Costs, Liquidity Premia
JEL Classification: C61, D11, D91, G11
Suggested Citation: Suggested Citation