Do Portfolio Manager Contracts Contract Portfolio Management?

Abstract

Most mutual fund managers have performance-based contracts. Our theory predicts that mutual fund managers with asymmetric contracts and mid-year performance close to their announced benchmark increase their portfolio risk in the second part of the year. As predicted by our theory, performance deviation from the benchmark decreases risk-shifting only for managers with performance contracts. Deviation from the benchmark dominates incentives from the flow-performance relation, suggesting that risk-shifting is motivated more by management contracts than by a tournament to capture flows.

How Does Illiquidity Affect Delegated Portfolio Choice?

“…This suggests that self-designated benchmarks appear to encourage risk shifting to a larger extent than tournaments. This result is consistent with the findings of Reed and Wu (2005) and Lee et al (2019).…”

“…14 This suggests that self-designated benchmarks appear to encourage risk shifting to a larger extent than tournaments. This result is consistent with Reed and Wu (2005) and Lee, Trzcinka, and Venkatesan (2019), who also find that fund managers tend to shift risk in response to beating their benchmarks but not in response to beating their median peer funds. 12 In our model, as in that of Basak et al (2007), any deviation from the benchmark is inherently risky.…”

Competition and cooperation in mutual fund families

“…Using the 2005 SEC rule change requiring investment advisors to detail the determinants of manager compensation, Ma, Tang, and Gomez (2018) analyze a set of manager incentive variables including whether or not a manager's compensation is based on fund performance, advisor profitability, and whether or not it is paid via deferred compensation. Lee, Trzcinka, and Venkatesan (2018) also collect manager compensation variables to revisit the manager risk-shifting hypothesis. They identify whether or not a manager's bonus is determined relative to a benchmark and how clearly that benchmark is identified.…”

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

“…Such fund ownership by portfolio managers could also serve as an incentive alignment mechanism. Studies show that managerial fund ownership is associated with superior fund performance and less agency‐induced risk‐taking (e.g., Khorana, Servaes, and Wedge (), Lee, Trzcinka, and Venkatesan (), Ma and Tang ()). We therefore collect data on managerial fund ownership ( Fund ownership ) and test whether fund ownership works as a substitute for performance‐based compensation.…”