Moral Hazard in Mutual Fund Management: The Quality-Assuring Role of Fees

We model the role of premium fees in assuring the quality of active mutual fund management. Active management is a prototype of an experience good subject to moral hazard. Investors cannot tell high quality management from low quality management until after the fact. An active manager might promise to incur costly effort researching profitable portfolio selection in exchange for a fee sufficient to compensate for his higher research costs. If investors were to find this promise credible, they would buy shares until their expected returns, net of fees, just equalled investing in, say, the market index. The manager might then shirk by forgoing costly research (`closet index') 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, which act as a `quality assuring bond', or `efficiency wage'. Our model has a number of revealing extensions and comparative statics.