Convex Incentives and Liquidity Premia

Abstract

We show that convexities in investors' preferences significantly amplify the effect of transaction costs on liquidity premia. To maximize year-end bonuses, fund managers with negative benchmark-adjusted performance have an incentive to take excessive risks. However, trading costs hinder their ability to do so. Therefore, larger liquidity premia are required to compensate for increased turnover and lower bonuses ensuing from suboptimal risk-taking. These results are robust to alternative sources of convexity such as prospect theory and status concerns. Using data on actively-managed mutual funds, we provide empirical support for the novel predictions of our theoretical model.

Keywords: Mutual Funds, Convex Incentives, Transaction Costs, Liquidity Premia

JEL Classification: C61, D11, D91, G11