Performance Evaluation, Contracts, and Flows in Efficient Markets

A common misconception in finance is that investors who believe in an efficient market will not invest with an active fund manager. In this paper I develop a model of active money management in which both the investor and the fund manager believe that the market is efficient and that all assets are fairly priced. Furthermore traditional performance measures would not be positive for the manager. But despite this the investor still finds it desirable to invest with the manager. The model yields equilibrium contracts, performance measures, and performance/flow relationships that conform with those we observe in the mutual fund industry