Endogenous Closet Indexing in Active Management

Abstract

We consider a model of active asset management in which mutual fund managers exert unobservable effort to earn excess returns. Investors allocate capital to both actively managed funds and passively managed products (e.g., index funds or ETFs). In the model's equilibrium, investors are indifferent between investing an additional dollar with an active manager or with a passively managed product. As passively managed products become more attractive to investors, active managers' revenues from portfolio-management services fall, reducing their effort incentives. The analysis relates recent trends in management fees and holdings-based measures of moral hazard. Furthermore, we provide novel empirical predictions.