Asset Management Contracts and Equilibrium Prices

We model asset management as a continuum between active and passive: managers can deviate from benchmark indices to exploit noise trader–induced distortions, but agency frictions constrain these deviations. Because constraints force buy assets that they underweight when appreciate, overvalued have high volatility, the risk-return relationship becomes inverted. Distortions are more severe for than undervalued ones because trading against former entails risk tighter constraints. provide empirical evidence supporting our model’s main mechanisms. Using data, we infer constraints’ tightness compute measure of effective arbitrage capital.