Combining Skill and Capital: Alternate Mechanisms for Achieving an Optimal Fund Size

Size Matters: While a fund manager’s skill is the basis of the fund’s alpha, that alpha will be declining with fund size. This study examines contracts that lead to the optimal combination of human capital and financial capital. When there is an information asymmetry about a manager’s skill, there is a natural role for an investment bank that does have the ability to evaluate managers and also has the capital necessary to back a performance guarantee to uninformed outside suppliers of capital. The manager and her bank-backer will enjoy the entire value-added by her skill. Institutionally-backed active managers have the correct incentive to take into account both the positive (direct) and negative (indirect) effects of growing the fund. If the competitive advantage associated with achieving the optimal fund size outweighs the contracting costs between active managers and their financial backers, such arrangements will become the dominant model for the active management industry