DP10438 The quality-assuring role of mutual fund advisory fees

Author(s): Michel Antoine Habib, D. Bruce Johnsen
Publication Date: February 2015
Keyword(s): advisory fees, closet indexing, excessive fees, open-access, quality-assurance
JEL(s): D23, D86, G23, L22
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10438

Active fund managers implicitly promise to research profitable portfolio selection. But active management is an experience good subject to moral hazard. Investors cannot tell high from low quality up front and therefore fear manager shirking. We show how the parties mitigate the moral hazard by paying the manager a premium fee sufficiently high that the manager's one-time gain from shirking is less than the capitalized value of the premium stream he earns from maintaining his promise to provide high quality. Premium advisory fees act as a quality-assuring bond. Our model has a number of revealing extensions and comparative statics.