Relative performance objectives in financial markets

Money management is an activity in which agents are often evaluated on the basis of their relative performance. In this article, I consider an economy in which (i) investors use a relative performance rule to evaluate mutual fund managers and allocate money into funds, and (ii) fund managers receive an asset-based compensation. Such fund-picking rules and compensation schemes generate relative performance objectives for fund managers. I study the consequences of this for the mutual fund industry in terms of the number of competing funds and trading strategies. I show that, with respect to absolute performance maximization, relative performance objectives increase the riskiness of investment strategies and reduces the number of low-quality funds. Overall, relative performance objectives increase investors' expected return.