Asset Management Contracts and Equilibrium Prices

Abstract

We study the joint determination of fund managers ’ contracts and equilibrium asset prices. Because of agency frictions, investors make managers ’ fees more sensitive to performance and benchmark performance against a market index. This makes managers unwilling to deviate from the index and exacerbates price distortions. Because trading against overvaluation ex-poses managers to greater risk of deviating from the index than trading against undervaluation, agency frictions bias the aggregate market upwards. They can also generate a negative rela-tionship between risk and return because they raise the volatility of overvalued assets. Socially optimal contracts provide steeper performance incentives and cause larger pricing distortions than privately optimal contracts