Fake Alphas, Tail Risk and Reputation Traps

Abstract

This paper presents a model in which the investment funds’ desire to enhance their reputation is decisive in determining the severity of aggregate shocks. Fund managers can generate active returns at a disutility or try to time the market, while investors learn about the managers’ skill by observing past returns. During booms, star funds exploit their status by extracting higher rents from investors, while poor performers may end up in a reputation trap, limiting their ability to attract investment. In a crisis, the funds exploit their reputation more frequently and tend to exacerbate fluctuations insofar as in the search for higher short-term returns they expose investors’ capital to tail risk. The model’s predictions on the effect of volatility, skewness of returns and inflows of funds, are all supported by recent empirical evidence on fund managers’ behavior.