Family matters: How internal incentives shape outcomes for fund firms

Author: Melissa Jackson

Incentive

You know that adage about how if a bear is chasing you, you don’t actually have to outrun it, you just need to outrun the other guy? Bear (or bull) notwithstanding, there’s an element of that mindset at work among mutual fund managers chasing competitive performance bonuses: Outperform your peers; collect a bigger bonus. 

Bonus payouts help investment companies retain good managers and maximize performance. But it turns out that competitive incentives aren’t the only type used to motivate mutual fund managers, according to Rafael Zambrana, an assistant professor of finance at the University of Notre Dame’s Mendoza College of Business. Some firms also appear to leverage cooperative incentives (e.g., bonuses based on advisor-level profitability or share ownership in the advisor) within a mutual fund family to drive manager behavior. Such incentives encourage managers to prioritize maximizing the value of the overall investment advisor and cross-subsidize their strategies, potentially at the expense of the manager’s own fund performance. 

Rafael Zambrana

Zambrana, along with Richard Evans of the University of Virginia and Melissa Prado of the Universidade NOVA de Lisboa, explored the significance and ramifications of different incentive strategies for mutual fund families and their clients in their paper “Competition and Cooperation in Mutual Fund Families,” published in April in the Journal of Financial Economics. 

“Our analysis helps to identify the impact of these two different compensation approaches and the characteristics of investment advisors who choose cooperative or competitive incentive schemes,” says Zambrana, who teaches corporate finance. “Because cooperative versus competitive incentives have important implications for the risk and return of funds, our results have important implications for institutional and retail investors and those investment professionals who manage their investments.”

Using publicly available data from actively managed U.S. mutual funds from between 1992-2015, the researchers looked at underlying compensation mechanisms as well as other indicators to gain insight into which fund families had relatively more cooperative or competitive environments. It turns out the incentive mechanism used has an impact on fund performance and risk and is associated with different clientele of these asset managers. 

When mutual fund families offer competitive incentives, funds perform better and have a greater percentage of star funds than cooperative advisors, the study found. However, the funds also experience greater return dispersion — more winners and losers — and more volatile cash flows. “We find that competitive incentives result in higher average performance consistent with either incentivizing greater effort on the part of managers or attracting managers with higher ability,” the authors wrote. 

When the researchers looked at those offering cooperative incentive schemes, they found lower-than-average fund performance but a better track record of retaining assets and more stable cash flows and returns. Cooperative incentives, they wrote, “align fund manager incentives with those of the firm. Fund managers are willing to sacrifice the performance of their own fund to support other funds in the family that are of strategic importance. The overall result is greater cash flow stability.” 

Cooperative advisors tended to manage assets for retail investors and market their fund offerings via a broker-distribution channel, the team found, noting that this is “consistent with investor demand for nonperformance characteristics.”The outcomes associated with each incentive scheme appeal to different types of investors, the researchers observed. They found that competitive fund families were more likely to manage institutional assets and distribute funds directly to more sophisticated investors. The “quality signal about each manager is clearer in a competitive fund family since fund performance is more likely to represent manager ability than intrafamily support,” they wrote. “If institutional investors benefit from searching for superior managers, they would be more likely to search among competitively incentivized fund managers.” 

Based on their findings, Zambrana says, the competitive compensation model works well for fund families seeking institutional investors, who have lower search costs and greater ability to discern talented managers. “At the same time,” he says, “for retail investors who are less able to discern manager skill, the greater dispersion in fund performance across funds managed by competitive advisors would result in greater investment risk.”

These results provide insight in the importance of compensation incentives in assessing the potential added value and the effectiveness of collaboration of large investment organizations.