A principal can observe both the output and input of an agent who works at a job involving multiple tasks. We provide a simple theory that explains why it may be optimal for the principal to use only an output-based incentive contract, even though the principal can monitor the agent's actions perfectly in all but one task and knows exactly which action is optimal for each task.

Using a large sample of hedge fund manager characteristics, we provide one of the first comprehensive studies on the impact of manager characteristics, such as education and career concern, on hedge fund performances. We document differential ability among hedge fund managers in either generating risk-adjusted returns or running hedge funds as a business. In particular, we find that managers from higher-SAT (Scholastic Aptitude Test) undergraduate institutions tend to have higher raw and risk-adjusted returns, more inflows, and take fewer risks. Unlike mutual funds, we find a rather symmetric relation between hedge fund flows and past performance, and that hedge fund flows do not have a significant negative impact on future performance.

The shape of the volatility smirk has significant cross-sectional predictive power for future equity returns. Stocks exhibiting the steepest smirks in their traded options underperform stocks with the least pronounced volatility smirks in their options by 10.9% per year on a risk-adjusted basis. This predictability persists for at least 6 months, and firms with the steepest volatility smirks are those experiencing the worst earnings shocks in the following quarter. The results are consistent with the notion that informed traders with negative news prefer to trade out-of-the-money put options, and that the equity market is slow in incorporating the information embedded in volatility smirks.