Reputation and Portfolio Management Contracts

Empirical research in finance has documented a strong positive and convex relationship between investment performance and flows in and out of managed portfolios such as mutual funds. It is also well-known that fee contracts for portfolio managers give the manager a fixed-fraction of assets under management so the manager's compensation grows with flows into the fund. Berk and Green (2004) was an attempt to create a model which is consistent with these observations. However that paper suffers from serious flaws. In this paper I explain the flaws as well as develop a model of optimal contracting between managers and investors in a world where investors update about managerial skill. The model implies a convex performance/flow relationship such as is found in the data..