The Effect of Market Conditions and Career Concerns in the Fund Industry

Abstract

This paper builds a model of delegated portfolio management to study the interplay between the career concerns of a manager and the prevailing market conditions. Investors allocate funds between a market index and a manager, who has private information about her ability to generate idiosyncratic returns. In each period, the investors observe the manager's decision to either follow a market neutral strategy, or an index tracking one. It is shown that the latter always results in a loss of reputation, reflected also on the fund's flows. This loss is smaller in bull markets, when investors expect more managers to use high beta strategies. As a result, a manager's performance in a bull market is less informative about her ability than in bear markets, because a high beta strategy does not rely on it. We empirically find that flows of funds that follow high beta strategies are less responsive to the fund's performance than those that follow market neutral strategies. Finally, we verify that the flow-performance sensitivity is higher in bear markets than in bull markets.