Reputation and Performance Fee Effects on Portfolio Choice by Investment Advisers

This paper considers a two-period model of investment management. Investors decide how to 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 advisor or the other to use his private information about investment returns too aggressively in the first period. Using the information too aggressively leads to a single-period welfare loss for advisors and investors. Reputation effects cause mutual funds to be riskier than in one-period or single-adviser settings. Commitment on the part of investors not to reallocate their investment among advisors can result in superior ex ante expected payoffs to investors. The adoption of performance fees also mitigates the undesirable consequences of fund managers’ concerns for their reputations.