Asset Management Contracts and Equilibrium Prices

We study the joint determination of fund managers’ contracts and equilibrium asset prices. Because of agency frictions, investors make managers’ fees more sensitive to performance and benchmark performance against a market index. This makes managers unwilling to deviate from the index and exacerbates price distortions. Because trading against overvaluation exposes managers to greater risk of deviating from the index than trading against undervaluation, agency frictions bias the aggregate market upwards. They can also generate a negative relationship between risk and return because they raise the volatility of overvalued assets. Socially optimal contracts provide steeper performance incentives and cause larger pricing distortions than privately optimal contracts. ∗[email protected], [email protected], [email protected]. We thank Daniel Andrei, Jonathan Berk, Bruno Biais, Oliver Boguth, Jennifer Carpenter, Sergey Chernenko, Chris Darnell, Peter DeMarzo, Ken French, Diego Garcia, Jeremy Grantham, Zhiguo He, Ron Kaniel, Dmitry Orlov, seminar participants at Bocconi, Boston University, CEU, Cheung Kong, Collegio Carlo Alberto, Dartmouth, LSE, Maryland, Stanford, Toulouse, UBC, Yale and conference participants at Adam Smith Workshop in Asset Pricing, AEA, BIS, CRETE, ESSFM Gerzenzee, FIRS, FRIC, FTG Meeting, Jackson Hole, LSE PWC, NBER Asset Pricing, SFS Cavalcade, Utah Winter Finance, and WFA for helpful comments.