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Rewarding Trading Skills without Inducing Gambling

Author

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  • IGOR MAKAROV
  • GUILLAUME PLANTIN

Abstract

type="main"> This paper develops a model of active asset management in which fund managers may forgo alpha-generating strategies, preferring instead to make negative-alpha trades that enable them to temporarily manipulate investors' perceptions of their skills. We show that such trades are optimally generated by taking on hidden tail risk, and are more likely to occur when fund managers are impatient and when their trading skills are scalable, and generate a high profit per unit of risk. We propose long-term contracts that deter this behavior by dynamically adjusting the dates on which the manager is compensated in response to her cumulative performance.

Suggested Citation

  • Igor Makarov & Guillaume Plantin, 2015. "Rewarding Trading Skills without Inducing Gambling," Journal of Finance, American Finance Association, vol. 70(3), pages 925-962, June.
    • Handle: RePEc:bla:jfinan:v:70:y:2015:i:3:p:925-962
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    1. Ravi Jagannathan & Alexey Malakhov & Dmitry Novikov, 2010. "Do Hot Hands Exist among Hedge Fund Managers? An Empirical Evaluation," Journal of Finance, American Finance Association, vol. 65(1), pages 217-255, February.
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    3. Kosowski, Robert & Naik, Narayan Y. & Teo, Melvyn, 2007. "Do hedge funds deliver alpha? A Bayesian and bootstrap analysis," Journal of Financial Economics, Elsevier, vol. 84(1), pages 229-264, April.
    4. Jonathan B. Berk & Richard C. Green, 2004. "Mutual Fund Flows and Performance in Rational Markets," Journal of Political Economy, University of Chicago Press, vol. 112(6), pages 1269-1295, December.
    5. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
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