Fake Alphas, Tail Risk and Reputation Traps

Abstract

This paper develops a model of active asset management where a fraction of managers have skill and invest alongside unskilled managers who can generate active returns at a disutility. Because of agency frictions, star funds exploit their status by extracting higher rents from investors and by exposing them to tail risk, while poor performers may end up in a reputation trap, limiting their ability to attract investment. These effects exacerbate fluctuations, especially in times of high-volatility. Moreover, there exists a feedback effect between the managers’ reputation and the compensation for selling disaster insurance which exacerbates agency frictions.

Keywords: reputation, alphas, flight to safety, hedge funds, John Paulson

JEL Classification: D83, C73, G12