Rewarding Trading Skills Without Inducing Gambling

Guillaume Plantin (TSE-CRM)

December 7, 2010, 11:00–12:30


Room MF 323

Economic Theory Seminar


This paper develops a model of active portfolio management in which fund managers may secretly gamble in order to manipulate their reputation and attract more funds. We show that such trading strategies may expose investors to severe losses and are more likely to occur when fund managers are impatient, their trading skills are scalable and generate higher pro t per unit of risk. We study investment management contracts that deter this behavior. If investors are short-lived, then the manager must leave rents to investors in order to credibly commit not to gamble. If investors are long-lived, contracts that increase but defer expected bonuses after an outstanding performance implement the first-best. Our model can explain a number of observed di erences in performance between mutual and hedge funds. In particular, it explains why persistence in net risk-adjusted returns can be higher for hedge funds, and o ers a rationale for the prevalence of high-water mark contracts.


Guillaume Plantin (TSE-CRM), Rewarding Trading Skills Without Inducing Gambling, Economic Theory Seminar, Toulouse: TSE, December 7, 2010, 11:00–12:30, room MF 323.