Reputation Effects in Portfolio Management

This paper analyzes a model of moral hazard in portfolio management. Managers wish to earn the higher fees associated with active management but are averse to the effort of identifying superior trading strategies through research. Previous research has focused on contracts which offer explicit incentives. In this paper I address optimal contracting between an investor and a portfolio manager when reputation building is possible. I model reputation in a somewhat different manner than some previous research in which both contracting parties are unsure of the agent’s ability. Here only the investor is unsure about the agent’s skill. No restrictions are made on the form of the contracts. The model predicts that larger funds, or those with higher reputations, will be more likely to give performance bonuses to managers. ∗Heber Farnsworth, John M. Olin School of Business, Washington University, Campus Box 1133, One Brookings Drive, St. Louis, MO 63130-4899, tel: (314) 935-4221, fax: (314) 935-6359, mailto:[email protected]