Portfolio Manager Compensation in the U.S. Mutual Fund Industry

We study compensation contracts of individual portfolio managers using hand‐collected data of over 4,500 U.S. mutual funds. Variations in the compensation structures are broadly consistent with an optimal contracting equilibrium. The likelihood of explicit performance‐based incentives is positively correlated with the intensity of agency conflicts, as proxied by the advisor's clientele dispersion, its affiliations in the financial industry, and its ownership structure. Investor sophistication and the threat of dismissal in outsourced funds serve as substitutes for explicit performance‐based incentives. Finally, we find little evidence of differences in future performance associated with any particular compensation arrangement.     

Book Reviews

Official Reserves and Currency Management in Asia: Myth, Reality and the Future: Geneva Reports on the World Economy 7 by HANS GENBERG, ROBERT McCAULEY, YUNG CHUL PARK and AVINASH PERSAUD (London: Centre for Economic Policy Research, 2005), pp. 128, £25.00 paperback, ISBN 1 898128 90 1. Growth, Inequality and Poverty: Prospects for Pro‐Poor Economic Development by ANTHONY SHORROCKS and ROLPH VAN DER HOEVEN (eds.) (Oxford: Oxford University Press, 2005), pp. 283, paperback, ISBN 0 19 928824 2. Competition and Growth: Reconciling Theory and Evidence by PHILIPPE AGHION and RACHEL GRIFFITH (Cambridge, MA: MIT Press, 2005), pp. 104, £18.50 hardback, ISBN 0 262 01218 9. The World Trade Organization. A Very Short Introduction by AMRITA NARLIKAR (Oxford: Oxford University Press, 2005), pp. 175, £6.99, paperback, ISBN 0 19 280608 4.     

Why does the velocity of money move pro‐cyclically?

The velocity of money usually rises in expansions and falls in recessions This paper explains this pro‐cyclical movement of velocity using two ideas: (i) during business cycles the movement of investment and consumption of durable goods has a larger amplitude than consumption of non‐durable goods and services; (ii) the velocity associated with expenditure on investment and durable goods is much higher than the velocity associated with consumption of non‐durable goods and services, because the former expenditures are synchronized with the attainment of money by economic agents whereas the latter are not. In this setting, the rise in the weight of expenditure in durable goods relative to the weight of non‐durable goods and services, which occurs during expansions, generates an increase in the average velocity of circulation. The opposite happens during recessions and thus velocity moves pro‐cyclically.     

Favoritism in Mutual Fund Families? Evidence on Strategic Cross‐Fund Subsidization

We investigate whether mutual fund families strategically transfer performance across member funds to favor those more likely to increase overall family profits. We find that “high family value” funds (i.e., high fees or high past performers) overperform at the expense of “low value” funds. Such a performance gap is above the one existing between similar funds not affiliated with the same family. Better allocations of underpriced initial public offering deals and opposite trades across member funds partly explain why high value funds overperform. Our findings highlight how the family organization prevalent in the mutual fund industry generates distortions in delegated asset management.     

Dynamic Portfolio Selection by Augmenting the Asset Space

We present a novel approach to dynamic portfolio selection that is as easy to implement as the static Markowitz paradigm. We expand the set of assets to include mechanically managed portfolios and optimize statically in this extended asset space. We consider “conditional” portfolios, which invest in each asset an amount proportional to conditioning variables, and “timing” portfolios, which invest in each asset for a single period and in the risk‐free asset for all other periods. The static choice of these managed portfolios represents a dynamic strategy that closely approximates the optimal dynamic strategy for horizons up to 5 years.     

Diagnostic Expectations and Credit Cycles

We present a model of credit cycles arising from diagnostic expectations—a belief formation mechanism based on Kahneman and Tversky's representativeness heuristic. Diagnostic expectations overweight future outcomes that become more likely in light of incoming data. The expectations formation rule is forward looking and depends on the underlying stochastic process, and thus is immune to the Lucas critique. Diagnostic expectations reconcile extrapolation and neglect of risk in a unified framework. In our model, credit spreads are excessively volatile, overreact to news, and are subject to predictable reversals. These dynamics can account for several features of credit cycles and macroeconomic volatility.     

Fiscal Requirements for Dynamic and Real Determinacies in Economies with Private Provision of Liquidity: A Monetarist Assessment

We study the impact of fiscal policies on the inherent links between inflation, unemployment, and asset prices in an environment where firms provide liquidity and the central bank follows a constant money growth rate rule. Firms, other than hiring workers, also supply private assets that are not only useful as a store of value but also as collateral. When firms are not taxed and public debt is scarce, the economy is non-Ricardian so that real indeterminacies can be observed. Moreover, labor market characteristics do not affect the demand for government liabilities. However, when agents face public and private asset scarcity, labor market conditions then impact asset prices and inflation. We further show that irrespective of the type of asset scarcity agents face, when firms are taxed non-ad valorem, not only the level of tax revenues but also its composition matter for real allocations. Moreover, we show that labor market conditions directly affect the dynamics of all government liabilities and inflation.     

LEGAL CORRUPTION

We challenge the conventional definition of corruption through the analysis of legal forms of corruption, and by devoting special attention to influence induced by the private sector. This paper studies the determinants of the world pattern of legal and illegal corruption by proposing a simple theoretical model of endogenous corruption and related legal framework, and its thorough empirical test. Three types of equilibrium outcomes are identified: one based on illegal corruption, where the elite does not face any binding incentives to limit corruption; one centered around legal corruption, where the elite must incur a cost to legally protect corruption; and finally a no‐corruption outcome, where the population is able to effectively react to corruption. Testable implications from the model are derived based on country‐wide parameters. Crucially, we use a rich corporate survey, including 8,279 firms in 104 countries, tailored for this research, and featuring measures of legal corruption that are novel to the literature. The microdimension of the database enables improving on familiar shortcomings associated with the use of endogeneity‐prone, country‐wide indices of perceived corruption. The empirical results, making use of a broad range of proxies and sources, generally validate the model's explanations.