Portfolio Manager Compensation in the U.S. Mutual Fund Industry

Linlin Ma is Assistant Professor of Finance at Northeastern University D’Amore-McKim School of Business; Yuehua Tang is Assistant Professor of Finance at University of Florida Warrington College of Business; and Juan-Pedro Gomez is Associate Professor at IE University Business School in Madrid, Spain. This post is based on their recent article, forthcoming in the Journal of Finance.

According to the Investment Company Institute, about half of all households in the United States invest in mutual funds, and the assets managed by them totaled more than $16 trillion at year-end 2016. Given the importance of mutual funds in the economy, understanding fund managers’ incentives is a key issue for academics, regulators, practitioners, and individual investors. Due to lack of data on individual fund manager incentives, the literature has focused primarily on the design of the advisory contracts between fund investors and investment advisors (i.e., asset management companies). Little is known about the compensation contracts of the actual decision makers—individual portfolio managers hired by advisors to manage the fund portfolio on a daily basis. Our article, Portfolio Manager Compensation in the U.S. Mutual Fund Industry, attempts to fill this gap.

In March 2005, the U.S. Securities and Exchange Commission (SEC) adopted a new rule requiring mutual funds to disclose the compensation structure of their portfolio managers in the Statement of Additional Information (SAI). For instance, mutual funds need to disclose whether portfolio manager compensation is fixed or variable, and whether compensation is based on the fund’s investment performance and/or assets under management (AUM). For performance-based compensation, funds are required to identify any benchmark used to measure performance and to state the length of the period over which performance is measured. In our study, we hand-collect the information on portfolio manager compensation structures from the SAIs for a sample of over 4,500 U.S. open-end mutual funds over the period 2006–2011. We analyze this mandatorily disclosed information to enhance our understanding of managerial incentives in the U.S. mutual fund industry and to test the predictions from models on portfolio delegation and contract design.

What Do We Find?

How are individual portfolio managers compensated?

First, almost all funds report that their portfolio managers receive variable bonus-type compensation as opposed to fixed salary. Second, the bonus component of compensation is explicitly tied to the fund’s investment performance for 79.0% of sample funds. The performance evaluation window ranges from one quarter to ten years, and the average evaluation window is three years. Third, for about half the sample, the manager’s bonus is directly linked to the overall profitability of the advisor. Fourth, only 19.6% of sample funds explicitly mention that the advisor considers the fund’s AUM when deciding manager bonuses. Finally, deferred compensation is present in almost 30% of the sample funds. These stylized facts contrast with the evidence on advisory contracts in the U.S., where AUM-based advisory fees are the predominant structure, and performance-based advisory fee is rarely observed.

About half of the funds voluntarily release information on the relative weights of potential bonuses (i.e., maximum bonus opportunity) and base salary. Among the funds that disclose quantitative information, 35% of them report a bonus/salary ratio higher than 200%; about 70% report a ratio higher than or equal to 100%. For those funds that disclose qualitative information, about half of the cases claim that the bonus incentive is greater than base salary, while the other half mention that the bonus can be a significant part of total compensation.

Why are they compensated this way?

Our unique data allow us to analyze for the first time the heterogeneity in the design of portfolio manager compensation in the U.S. mutual fund industry using a rich set of variables at the advisor, manager, and fund level proposed in the literature. Overall, our results suggest that portfolio manager compensation contracts are designed to mitigate agency conflicts in the absence of alternative monitoring mechanisms, which is broadly consistent with an optimal contracting equilibrium.

In particular, our determinant analyses test three broad hypotheses. Our first hypothesis states that performance-based contracts are costly to implement and will emerge as optimal only when agency conflicts are severe. We find strong and robust support for this prediction. In particular, performance-based pay is more likely when (i) the advisor has a more disperse clientele and is arguably more likely to engage in cross-clientele-subsidization; (ii) the advisor is affiliated to a bank or a broker-dealer, hence, more prone to take decisions that enhance the value of the bank or the broker rather than fund performance; or (iii) the portfolio manager is not the founder or a significant stakeholder of the advisor, that is, in the absence of the incentive alignment induced by ownership. Second, we find partial evidence in support of our second hypothesis, which claims that alternative mechanisms make explicit contract incentives redundant. We find that (i) investor sophistication, (ii) market discipline via fund flow-performance relation, and (iii) the threat of dismissal in outsourced funds work as substitutes for explicit performance-based incentives, but do not find evidence on the substitution effect for fund ownership by portfolio managers. Third, we test whether portfolio manager characteristics are related to the design of compensation contracts. In particular, we do not find evidence on managerial industry experience, the number of fund managed, or team management having a significant impact on the likelihood of adopting performance-based pay. However, consistent with retention purpose, advisors in cities with higher competition proxied by total city AUM tend to use advisor-profit-based incentives more often.

Is portfolio manager compensation related to fund performance and fees?

First, we find little evidence of future performance difference (gross or net of fees) associated to any particular compensation arrangement (including performance-based pay) after controlling for a comprehensive list of advisor, fund, and portfolio manager variables used in the determinant analysis. This result is again consistent with an optimal contracting equilibrium. Second, we find that performance-based contracts are associated with higher fund advisory fees (either in percentage or dollar value). For funds that operate in an environment with high potential for agency conflicts, advisors optimally choose to compensate portfolio managers with explicit performance-based contacts, which are costly and require charging higher advisory fees. These funds make up for the advisory fee disadvantage by charging lower marketing and distribution fees. The two effects offset each other, resulting in no difference in total fund fees for investors across compensation contracts with and without performance-based pay.

Conclusions

Unlike the advisory contract, which is mostly based on the fund’s AUM, the majority of compensation contracts for individual portfolio managers include a bonus explicitly linked to investment performance. Much of the literature assumes that the compensation structure of investment advisors and individual portfolio managers coincides. Our evidence clearly suggests otherwise. In contrast to the tight regulation of advisory contracts, the SEC places no specific restriction on the compensation contracts of individual portfolio managers. Our evidence suggests that, in a less regulated setting, asymmetric, option-like performance-based incentives exist and constitute the dominant form of compensation for individual portfolio managers. Our study also provides new insights into the heterogeneity of portfolio manager compensation contracts. In particular, our analysis suggests that compensation contracts of portfolio managers are designed to mitigate agency conflicts in the absence of alternative monitoring mechanisms, which is consistent with an optimal contracting equilibrium.

The complete article is available for download here.

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