What are the equilibrium features of a dynamic financial market in which traders care about their reputation for ability? We modify a standard sequential trading model to include traders with career concerns. We show that this market cannot be informationally efficient: there is no equilibrium in which prices converge to the true value, even after an infinite sequence of trades. We characterize the most revealing equilibrium of this game and show that an increase in the strength of the traders’reputational concerns has a negative effect on the extent of information that can be revealed in equilibrium but a positive effect on market liquidity.

We present a simple theoretical model of the price impact of institutional herding. In our model, career-concerned fund managers interact with pro…t-motivated proprietary traders and monopolistic market makers in a pure dealer-market. The reputational concerns of fund managers generate an endogenous tendency to imitate past trades, which, in turn, impacts the prices of the assets they trade. In contrast, proprietary traders trade in a contrarian manner. We show that, in markets dominated by fund managers, assets persistently bought (sold) by fund managers trade at prices that are too high (low) and thus experience negative (positive) long-term returns, after uncertainty is resolved. The pattern of equilibrium trade is also consistent with increasing (decreasing) short-term transaction-price paths during or immediately after an institutional buy (sell) sequence. Our results provide a simple and stylized framework within which to interpret the empirical literature on the price impact of institutional herding. In addition, our paper generates several new testable implications.

We show that it is extremely difficult to devise incentive schemes that distinguish between fund managers who cannot deliver excess returns from those who can, unless investors have specific knowledge of the investment strategies being employed. Using a ‘performance‐mimicking ’ argument, we show that any fee structure that does not assess penalties for underperformance can be gamed by unskilled managers to generate fees that are at least as high, per dollar of expected returns, as the fees of the most skilled managers. We show further that standard proposals to reform the fee structure, such as imposing high water marks, delaying managers ’ bonus payments, forcing them to hold an equity stake, or assessing penalties for underperformance, are not enough to separate the skilled from the unskilled. We conclude that skilled managers will have to find ways other than their track records to distinguish themselves from the unskilled, or else the latter may drive out the former as in a classic lemons market.

This paper analyzes a model of fund managers ’ reputation concerns. It explains why “Nickel strategies” (strategies that earn small positive returns most of the time but occasionally lead to dramatic losses) are more popular among managers than the opposite “Black Swan strategies, ” (strategies that generate small losses most of the time but occasionally lead to large profits). A novel insight from the model is the fragile nature of the economy with reputation concerns: The interaction between managers’ reputation concern and investors ’ perception of managers ’ strategy choices may lead to multiple self-fulfilling equilibria. When the economy is in one equilibrium, managers have no incentive to change their strategies unless investors change their perceptions, and vice versa. This coordination problem implies slow-moving capital and may leave profitable opportunities unexploited for an extended period of time. Once the coordination problem is broken, however, the economy switches to the other equilibrium, leading to drastic capital relocation and price movements in the absence of news on fundamentals. This model sheds light on a number of stylized facts documented in the literature and also provides some new testable implications. JEL Classification Numbers: G11, G23.

As previous agency models have shown, fund managers with career concerns have an incentive to imitate the recent trading strategy of other managers. We embed this rational conformist tendency in a stylized financial market with limited arbitrage. Equilibrium prices incorporate a reputational premium or discount, which is a monotonic function of past trade between careerdrive traders and the rest of the market. Our prediction is tested with quarterly data on US institutional holdings from 1983 to 2004. We find evidence that stocks that have been persistently bought (sold) by insitutions in the past 3 to 5 quarters underperform (overperform) the rest of the market in the next 12 to 30 months. Our result is of a similar order of magnitude of — but cannot be reconduced to — other known price anomalies. Our findings challenge the mainstream view of the roles played by individuals and institutions in generating price anomalies.

Busts after periods of prolonged prosperity have been found to be catastrophic. Financial institutions increase their leverage and shift their portfolios towards projects that were previously considered risky. This results from institutions rationally updating their expectations and becoming more optimistic about the future prospects of the economy. Default is inevitably harsher when a bad shock occurs after periods of good news. Commonly used measures to forecast risk in the system, such as VIX, fail to do so, as they are biased by optimistic expectations. Competition among financial institutions for better relative performance exacerbates the boom-bust cycle. Keywords: Financial Instability·Minsky·Leverage·Optimism·Relative Performance JEL Classification: D83·E44·G01·G21 We are grateful to Regis Breton and Benjamin Klaus for their helpful comments and useful insights. All remaining errors are ours.

Preliminary and incomplete. Please do not circulate.

Busts after periods of prolonged prosperity have been found to be catastrophic. Financial institutions increase their leverage and shift their portfolios towards projects that were previously considered risky. This results from institutions rationally updating their expectations and becoming more optimistic about the future prospects of the economy. Default is inevitably harsher when a bad shock occurs after periods of good news. Commonly used measures to forecast risk in the system, such as VIX, fail to do so, as they are biased by optimistic expectations. Competition among financial institutions for better relative performance exacerbates the boom-bust cycle. We explore the relative advantages of alternative regulations in reducing financial fragility, and suggest a novel criterion.