Rewarding Trading Skills Without Inducing Gambling

This paper develops a model in which traders may secretly take fair bets in complete markets in order to temporarily manipulate their reputation and attract more funds. It then solves for contracts that mitigate this friction. Such contracts must ensure that the present value of the trader's future payoffs is not too convex in her reputation. If the trader can commit to a long-term contract, she can achieve this by committing to leave a fraction of her future excess returns to investors if she turns out to be highly skilled. If the trader cannot commit to such behavior, then investors optimally commit to overcompensate the trader if she turns out to be unskilled. In both cases, the net excess returns earned by competitive, uninformed investors exhibit persistence.