Like the proverbial carrot, when incentives are dangled in front of portfolio managers, they’ll work harder to meet their targets – even if your money is at risk.
New research from Assistant Finance Professor Shyam Venkatesan shows portfolio managers are taking more risks in hope of beating the benchmark, because their performance contracts reward them for outperforming, and that risk-taking costs investors $26 billion per year on average.
Since most portfolio managers have performance-based contracts, Venkatesan suggests there be more monitoring, compensation incentives be lowered, or portfolio managers also be charged for poor performance, to help mitigate the effects.
"I’m not saying that we should not give performance compensation. We should definitely give it, but maybe monitor it more closely or make it linear. Right now we pay people to do well, but we aren’t charging them for doing a poor job," he said. "Performance is directly affected by incentives. If you give people something, they’ll work harder for it, but what functional form that incentive takes is something we need to work toward."
Portfolio managers who invest in their own funds are also less likely to take risks.
"If they have some skin in the game, they will not do these high-risk moves," he said.
Compensation drives behaviour change
Venkatesan – along with Jung Hoon Lee, an Assistant Finance Professor at Tulane University’s Freeman School of Business, and Charles Trzcinka, a Finance Professor at Indiana University’s Kelley School of Business – looked at 3,265 U.S. equity mutual funds between 2000 and 2013. They found portfolio managers change their portfolio risk in the second half of the year, with respect to that in the first half of the year, when their compensation is tied to the fund’s performance in relation to the pre-defined benchmark.
Those who are closest to the benchmark shift the fund risk the most. Likewise those who are far below their benchmark also shift the fund’s volatility because their jobs, not just their compensation, is at stake.
Such behaviour toward risk-taking is not unusual. Venkatesan said sales people on commission may become more aggressive to meet their targets and there may be misreporting of performance/ profitability in firms’ accounting.
"Very few firms report a small loss. It’s easier for them to report profitability. Misreporting is like taking on risk," he said. "Compensation drives it and reputation drives it. Incentives drive behaviour change."
Venkatesan said the study is unique because it also compares the contracts between investment advisers and portfolio managers to exchange options, showing how the compensation paid to managers fluctuates because it is based on how much they beat the benchmark, or the performance of the broader asset class, which varies.
While contracts between shareholders and the investment advisers who sell the investment product are regulated, the contracts between investment advisers and the portfolio managers, who actually build and maintain the funds, are not.
The paper, "Mutual Fund Risk-Shifting and Management Contracts," is currently being reviewed by a finance journal.
Venkatesan said he became interested in the dual-level of agency in mutual funds and managerial compensation while doing his PhD. How these agents are paid has only recently come to light after the U.S. Securities and Exchange Commission mandated in 2005 that funds must disclose how they compensate fund managers. Funds began disclosing their prospectus benchmark in 2000.
"Those contracts were formerly never available. They still aren’t available. We only have snippets of these contracts and we can just see some key characteristics of these contracts," he said. "I think it’s important to talk about how these compensation structures affect investors’ profitability and returns."
Venkatesan joined Ivey in August 2017 and teaches courses in corporate valuation and empirical asset pricing in the HBA and PhD programs, respectively. He previously was a Visiting Assistant Professor of Finance at A.B. Freeman School of Business at Tulane University.