Convex Incentives and Liquidity Premia
65 Pages Posted: 21 Dec 2018
Date Written: December 3, 2018
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 becomes expensive and less effective at capturing flows and bonuses. In equilibrium, fund managers demand high expected stock returns to compensate for the direct and indirect effects of transaction costs. This framework generates high turnover and large liquidity premia endogenously, while existing models require exogenous time-variation in investment opportunities. We provide empirical support for the novel implications of our theoretical model.
Keywords: Mutual Funds, Convex Flows, Bonuses, Transaction Costs, Liquidity Premia
JEL Classification: C61, D11, D91, G11
Suggested Citation: Suggested Citation