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Reputation and performance fee effects on portfolio choice by investment advisers

Steven Huddart

This paper examines a two-period model of investment management. Investors reallocate their wealth between two mutual funds managed by different investment advisers after observing the performance of each adviser in the first period. A reputation effect causes one adviser to choose a portfolio in the first period that is extreme given his private information about asset returns. Extreme portfolios are costly for risk-averse advisers and investors because mutual funds are riskier than in one-period or single-adviser settings. Adoption of a performance fee mitigates undesirable reputation effects and results in superior ex ante payoffs to investors.

JEL Classification: G20, J33, L21.

Keywords: compensation, closed-end, fee, investment adviser, open-end.

Journal of Financial Markets Volume 2, Number 3, (August 1999) 227-271.

Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
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