Asset Management Contracts and Equilibrium Prices

Abstract

We derive equilibrium asset prices when fund managers deviate from benchmark indices to exploit noise-trader induced distortions but fund investors constrain these deviations. Because constraints force managers to buy assets that they underweight when these assets appreciate, overvalued assets have high volatility, and the risk-return relationship becomes inverted. Noise traders bias prices upward because constraints make it harder for managers to underweight overvalued assets, which have high volatility, than to overweight undervalued ones. We endogenize the constraints based on investors' uncertainty about managers' skill, and show that asset-pricing implications can be significant even for moderate numbers of unskilled managers.