Information Asymmetry and Incentives for Active Management

This paper examines the equilibrium consequences of strategic behavior of mutual fund managers who withhold information about their funds and their managerial ability. We show that under this information asymmetry, low skills in the industry can result in a growth of passive management. A separating equilibrium in which skilled managers actively manage funds arises only if their compensation depends on performance and their skills are su¢ ciently superior. A growth of passivelymanaged funds such as closet-index funds (Cremers and Petajisto (2007)), therefore, suggests that the mutual fund industry may lack performance-based compensation. In essence, the ‡ow-performance relationship, which has been considered an implicit performance fee, may not actually reward skills. Alternatively, more closet-indexing could derive from a diminution in skills— for example, due to a brain drain as skilled mutual fund managers migrate to the hedge fund or private equity industry.