“Brokerage Commissions, Perquisites, and Delegated Portfolio Management” by Fei DING
I use a simple three-agent setting to capture realistic features of the money management industry and highlight the importance of frictions in asset transactions. I explicitly model the price-setting process of a rational, profit-maximizing broker, who may pay the money manager perquisites (“perks”) in exchange for his business. While commissions come directly out of the investor’s portfolio, perks only benefit the manager and induce him to trade more. The contract that corrects the misalignments of interests produced by the broker is concave in portfolio payoffs. This concavity successfully reduces the manager’s trading frequency, but compromises his incentive to gather information. I show that in equilibrium, the investor balances cost minimization and information acquisition by offering the manager a contract that is close to being linear, and this results in the manager trading excessively to maximize the likelihood of excess returns. Strikingly, I find that even if the broker does provide valuable research services in the bundle, as long as his personal costs for such services are low, investors are better off when the brokerage industry is less competitive. Instead of lowering commissions, brokers compete by raising perks and financing them with higher fees. These theoretical findings are consistent with many well-known facts such as the high levels of institutional trading and the underperformance of actively managed funds. Important empirical and policy implications are also discussed.