Reputation and performance fee effects on portfolio choice by investment advisers 1 I am grateful fo

In large part, the form of investment advisers' compensation contracts is imposed by the Securities and Exchange Commission. Given these contractual forms, this paper considers the portfolio choices that emerge when advisers rationally cultivate their reputations. In a two-period model of investment management in which (i) investors reallocate their wealth across advisers after observing performance in the first period, and (ii) advisers' compensation is in the form of periodic asset fees, this paper shows 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. Imposing a performance fee ameliorates these distortions and results in superior ex ante payoffs to investors without altering adviser welfare. Numerical examples show that asset fees may increase or decrease as uninformed advisers enter the industry. Taking asset trading costs into account, performance fees are most likely to be used when (i) there are many investors with small amounts of wealth to invest, (ii) assets are difficult to buy directly (e.g., foreign stocks), or (iii) benchmark portfolios are not tradable (e.g., real estate). The analysis also suggests these mechanisms are most likely to be used when reputation considerations are acute: when young advisers have little history of investment returns or when differences in ability across managers are small.