Moral Hazard in Mutual Fund Management: the Role of Fees

Abstract: If markets are efficient, how can actively managed mutual funds be expected to outperform the market? Early empirical work found they cannot, concluding that the resources devoted to active management are socially wasteful and that the fees mutual fund investors pay for active management very likely reduce their returns. This view seems to have stuck, despite recent and sound theoretical findings that in an efficient market with rational shareholders any expectation of superior fund performance will prompt inflows to the fund until investor returns are normalized. If so, mutual fund management fees are irrelevant to investor returns. Lower fees will simply bring greater inflows until investors dissipate all excess returns. This paper shows how and why fund fees are relevant to investor welfare. Active fund management is an experience good subject to moral hazard; investors cannot tell high quality from low quality until after the fact. An active manager might promise to incur costly effort researching profitable stock selection in exchange for a fee sufficient to compensate for his higher research costs. Finding this promise credible, investors buy shares until their expected returns, net of fees, just equal the normal rate. The manager might then shirk (engage in "closet indexing") and pocket the excess fee, leaving investors worse off than if they had simply invested in the index. We model this moral hazard and show how it can be mitigated by paying the manager a premium fee sufficiently high that the one-time gain from shirking is less than the capitalized value of the premium stream the manager earns from maintaining his promise to provide high quality. Investors benefit from higher fees, rather than lower fees. Where quality is unobservable, any attempt to impose binding maximum fees will make investors worse off. Our model has a number of revealing extensions and comparative statics.