Rewarding Trading Skills without Inducing Gambling

Résumé

This paper develops a model of active asset management in which fund managers may forego alpha-generating strategies, preferring instead to make negative-alpha trades that enable them temporarily to manipulate investors' perceptions of their skills. We show that such trades are optimally generated by taking on hidden-tail risk, and that they are more likely to occur when fund managers are impatient, and when their trading skills are scalable and generate a high profit per unit of risk. We propose long-term contracts that deter this behavior by dynamically adjusting the dates on which the manager is compensated in response to her cumulative performance.