Explicit and implicit incentives in fund management

Abstract

Fund managers compete to attract new investors. Competition and fund management contracts provide implicit and explicit incentives for fund management. I study the combined effect of these two types of incentives on i) investors’ search for talented fund managers and on ii) talented fund managers’ use of private investment signals. I show that an intermediate level of competition yields less efficient use of private investment signals and a lower average rate of return than in the case of either a high or a low level of competition in the fund management industry. Furthermore, I show that although explicit incentives improve managers’ use of private information, they may harm new investors’ search for talented fund managers. Explicit incentives may improve current performance, but cause prospective performance of the fund industry to deteriorate.