Abstract We analyze fund managers’ reputation concerns in an equilibrium model, in which we tie together a number of seemingly unrelated phenomena. The model shows that because of reputation concerns, hedge fund managers, especially those with an average reputation, prefer strategies with negatively skewed return distributions. One subtle consequence of this preference is that capital sometimes appears slow moving, leaving profitable investment opportunities unexploited, yet other times appears fast moving, causing large capital relocation and price fluctuations in the absence of fundamental news. More broadly, the analysis demonstrates a limitation of market discipline: fund managers may distort their investments precisely because of market discipline.

Households with limited financial expertise sometimes attempt to avoid investment mistakes by delegating the management of their investments to experts. However, evidence on the efficacy of delegation has been mixed. This paper contributes to understanding the question: why is the acquired expertise of asset managers a limited substitute for investors’ lack of expertise? We consider an economy with investors (who vary in sophistication) and managers (who vary in skill). Unsophisticated investors’ lack of expertise makes it hard for them to distinguish skilled managers from unskilled ones. In the equilibrium that follows, investors exert little effort when searching for managers, leading to a suboptimal composition of managerial types entering the market. When unsophisticated investors are endowed with weak signals, they attempt to time their entry and exit from the market for managers, but their actions are predictable, so performance continues to suffer.