Performance Evaluation and Financial Market Runs

Abstract

This paper develops a model in which performance evaluation causes runs by fund managers and results in asset fire-sales. Performance evaluation nonetheless is efficient as it disciplines managers. Optimal performance evaluation combines absolute and relative components in order to make runs less likely. When runs induce large price discounts, this requires a high degree of absolute performance evaluation and a low degree of relative performance evaluation. The overall costs of using performance evaluation are shown to be decreasing in asset liquidity, implying that more developed financial markets should have more delegation. However, such markets are not less prone to runs since higher delegation offsets the stability-enhancing impact of asset liquidity.