Explicit and implicit incentives in fund management

Fund managers compete to attract new investors. Competition and fund management contracts provide (respectively) implicit and explicit incentives for fund management. I study the combined effect of these two types of incentives on i) investors’ search for talented fund managers and on ii) talented fund managers’ use of private investment signals. I show that a medium level of competition yields less efficient use of private investment signals and lower average rate of return than in the case of either a high or a low level of competition in the fund management industry. Furthermore, I show that although explicit incentives improve managers use of private information, they may harm new investors ’ search for talented fund managers. Explicit incentives may improve current performance, but deteriorate prospective performance of the fund industry.