Delegated Learning and Contract Commonality in Asset Management*

Michael Sockin and Mindy Z Xiaolan

Review of Finance, 2023, vol. 27, issue 6, 1931-1975

Abstract: We examine the pecuniary externalities that arise when active fund manager compensation contracts have common components. This commonality in the compensation structure and loadings on each component across funds reduces asset price informativeness, amplifies the distortions from active managers’ benchmark-hedging demand, and lowers the price of risk in financial markets. This is because contract commonality distorts investors’ capital allocation to active management, and active managers’ information acquisition and trading decisions. From a normative perspective, contract commonality increases the rigidity of the active industry size and performance-based fee. As a result, they do not vary enough with financial market conditions compared with a Planner’s economy. Quantitatively, an increase in asset payoff uncertainty increases the size and performance-based fee twice as much in the Planner economy compared with the decentralized economy. From a positive perspective, contract commonality contributes to the inconsistency of several widely adopted measures of active manager skill.

Keywords: Fund manager compensation; Benchmarking; Moral hazard; Information acquisition; Contract externality (search for similar items in EconPapers)
JEL-codes: D86 G12 G14 G23 J33 (search for similar items in EconPapers)
Date: 2023
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Citations: View citations in EconPapers (1)

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