Essays on financial markets

This dissertation consists of two chapters that examine agency issues in delegated portfolio management and one chapter that studies forecasts of stock market returns.;The first chapter proposes that the recent growth in passive management in the mutual fund industry (e.g., closet-indexing) is caused by a weaker flow-performance relationship amid low skills, noisy performance, and more outside competition. Using a model that accommodates both moral hazard and adverse selection, I show that when skills decrease, when performance becomes noisier, and when competition from other investment vehicles grows, active management does not add much value relative to passive management. As a result, performance compensation also decreases, which discourages active management, causing even skilled managers to track market indexes. Given that the flow-performance relationship can serve as performance compensation, this model predicts that a weaker flow-performance relationship leads to more indexing.;The second chapter shows that the flow-performance relationship indeed becomes weaker, as the first chapter argues. The relationship was convex prior to 2000, but is no longer convex. Variations in marginal flow contribute to the shape change and suggest that the relationship can serve as a dynamic incentive contract. The marginal flow to high performing funds is lower when markets are highly volatile and when performance dispersion across funds is lower. Moreover, I show that underperforming managers engage in less risk-shifting after 2000, which can be also explained by performance dispersion and market volatility. These results are consistent with the view that the convex flow-performance relationship provides managers with risk-shifting incentives.;The third chapter proposes that under certain circumstances such as when expected returns are highly persistent, predicting changes in returns and then adding current returns results in a better performance than predicting returns directly. Regressions of changes in stock returns on changes in household net worth (aggregate asset growth) provide stable coefficient estimates over time, which improve the out of sample predictive ability in terms of mean squared predictive error, when compared with the dividend-price ratio, "cay" and a yield spread. These results suggest that aggregate asset growth captures shocks to expected returns, a main component of changes in returns.