Do Portfolio Manager Contracts Contract Portfolio Management?

• Published date: 01 October 2019
• DOI: http://doi.org/10.1111/jofi.12823
• Author: SHYAM VENKATESAN,JUNG HOON LEE,CHARLES TRZCINKA
• Date: 01 October 2019

THE JOURNAL OF FINANCE •VOL. LXXIV, NO. 5 •OCTOBER 2019

Do Portfolio Manager Contracts Contract

Portfolio Management?

JUNG HOON LEE, CHARLES TRZCINKA, and SHYAM VENKATESAN∗

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.

CONTRACTING THEORY ASSERTS THAT investors can mitigate agency problems by

requiring high-incentive contracts for managers. In the context of delegated

portfolio management, in principle these contracts align managers’ payoffs

more closely with their performance, increasing their effort and leading to

superior performance for investors. However, Hart (2017) points out that man-

agers have residual control rights over the assets of a portfolio, that is, contracts

do not dictate portfolio choices because many choices are not observable. The

economic reality of residual control by the portfolio manager creates incentives

that are seldom discussed in the context of optimal contracts. This motivates us

to study the contracts between the investment advisor and mutual fund man-

agers and focus on one ramification of these contracts: mid-year risk-shifting.

Investors in mutual funds and the board of directors collectively delegate

portfolio management to an investment advisor, who in turn hires a portfolio

∗Jung Hoon Lee is at the Freeman School of Business, Tulane University. Charles Trzcinka is

at the Kelley School of Business, Indiana University. Shyam Venkatesan is at the Ivey Business

School, University of Western Ontario. We thank the Editor (Stefan Nagel), the Associate Editor,

an anonymous referee, Vikas Agarwal, Matt Billet, Hsiu-lang Chen, Susan Christofersen (AFA

Discussant), Martijn Cremers, TedFee, Craig Holden, Ryan Israelsen, Ron Kaniel, David Lesmond,

Pedro Matos, VeronicaPool, Christopher Schwarz, Clemens Sialm, Laura Starks (FRA discussant),

Matthew Spiegel, YuehuaTang, and Jun Yang,for their valuable comments. We also benefited from

comments received during presentations at the 2015 Financial Research Association (FRA), 2015

Northern Finance Association (NFA), 2016 Financial Intermediation Research Society (FIRS),

and 2018 American Finance Association (AFA) conferences, as well as at seminars at Indiana

University, Lehigh University, Tulane University, University of Illinois at Chicago, University

of Massachusetts Boston, University of Missouri, University of Notre Dame, and University of

Western Ontario. The authors do not have any potential conflicts of interest to disclose as identified

in the Journal of Finance’s disclosure policy.

DOI: 10.1111/jofi.12823

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2544 The Journal of Finance R

manager and pays the manager a salary. In a recent paper, Ma, Tang, and

G´

omez (2019) find that the vast majority of mutual fund managers have vari-

able compensation contracts based on the fund’s performance relative to a

specified benchmark. Moreover, these contracts are asymmetric: the manager

is not penalized if the fund underperforms the benchmark, giving them an

incentive to take additional risk. With the portfolio manager making day-to-

day investment decisions, this asymmetric contract should be an important

determinant of risk-shifting.

We focus on mid-year risk-shifting because of its prominence in financial

economics. Managers can change portfolio risk in numerous ways, making it

difficult to write contracts that prohibit risk-shifting (i.e., Huang, Sialm, and

Zhang (2011)). Traditionally, studies of mid-year risk-shifting motivated by

mutual fund tournaments focus on the contract between advisors and share-

holders (i.e., Brown, Harlow, and Starks (1996)). The advisors’ contract with

shareholders is typically specified as a percentage of the fund’s assets under

management (AUM) and should be symmetric if there is a performance bonus

(a “fulcrum” fee).1In sharp contrast, the contract with portfolio managers has

an option-like payoff whereby the value of the fund at the end of the year is

the underlying asset of the option and the stochastic benchmark is the strike

price. This paper is the first to examine the contract between the mutual fund

manager and the advisor as an exchange option as in Margrabe (1978)andto

derive the implications of that contract for mid-year risk-shifting.

Using the exchange option model, we show that the vega of the manager’s

contract, that is, the derivative of the option’s price with respect to the volatil-

ity of the portfolio, reaches its maximum value when the distance of the fund’s

return from the benchmark’s return is smallest. This is the point at which

volatility is most valuable to the manager. With this result, we hypothesize

that risk-shifting by the portfolio manager is inversely related to the distance

of the portfolio’s return from the benchmark’s return. However, the impact of

vega will likely be less important as the risk of being fired increases. Kho-

rana (1996) shows that management turnover is empirically related to poor

performance. In the theoretical dynamic investment allocation model of Car-

penter (2000), portfolio volatility converges to infinity as a managed portfolio

approaches bankruptcy. In such instances of extreme poor performance, the

portfolio manager’s desire to preserve their job dominates the vega of the op-

tion contract. Chen and Pennacchi (2009), who model the manager’s contract

relative to a benchmark, also arrive at a similar conclusion. However, their

model assumes that the manager competes in a tournament for flows. Finally,

Khorana (2001) finds evidence that managers engage in risk-shifting before

being replaced. Given these arguments, we hypothesize that there is a positive

relation between risk-shifting and extremely poor performance.

To test these hypotheses, we collect a sample of 3,265 U.S. equity mutual

funds and match them with their announced benchmarks. We use the daily

1See section 205 (a) (1) of the Investment Advisers Act of 1940. See also Deli (2002), Elton,

Gruber, and Blake (2003), and Golec and Starks (2004).

Do Portfolio Manager Contracts Contract Portfolio Management? 2545

fund and benchmark returns to estimate the extent of risk-shifting. Given that

the outliers (or extremely underperforming funds) are clearly influential, we

run a quantile regression model that is robust to outliers. Our baseline results

show that the distance from the benchmark is significantly inversely related

to the ratio of the standard deviations (or risk-shifting ratio), controlling for

variables used in previous studies. This baseline result also holds when we use

the alternative holdings-based measure of Kempf, Ruenzi, and Thiele (2009)

to estimate intended risk-shifting. To ensure that an unlikely mechanical re-

lation is not driving our results, we follow Christoffersen and Simutin (2017)

and use the ratio of the two periods’ portfolio beta as another measure of risk-

shifting. Our results continue to hold. Our results also hold if we define the

evaluation period as a two-year window, the performance period as 1.5 years,

and the risk-shifting period as 0.5 years. Finally, we further corroborate our

findings by fitting a piecewise linear regression, which estimates a separate

slope coefficient for each region of the benchmark-adjusted excess return dis-

tribution. Our estimates clearly indicate that risk-shifting changes along the

excess return distribution.

Next, we hand-collect portfolio manager compensation data from the State-

ment of Additional Information (SAI) to capture the role of benchmarks in

explaining the heterogeneous risk-shifting decisions. We categorize funds into

three subgroups: funds with a clear compensation benchmark, funds with an

unclear compensation benchmark, and funds without a compensation bench-

mark. These subgroups display strikingly different risk-shifting behaviors.

Funds with a clear compensation benchmark shift their portfolio risk the most,

while no such evidence is found among funds that do not have performance-

based compensation. These results are in line with our prediction that risk-

shifting is driven by management contracts. Toclaim that managerial contracts

have a causal effect on funds’ risk choices, we match funds with performance-

based contracts (treated) to funds without performance-based contracts (con-

trol) on observable characteristics that, we believe, affect the funds’ assignment

to either of these two groups. We then assess the differences in risk-shifting re-

sponse between the two groups assuming that, once matched, the contract type

is uncorrelated with the unobservables. The results confirm our hypothesis

that, on average, compensation contracts, along with mid-year fund perfor-

mance, have a causal effect on the risk-shifting decision.

We also shed light on other perspectives of the contracting environment and

their effects on risk-shifting decisions. First, a manager’s ownership in the fund

significantly reduces risk-shifting. Second, the larger the active share of a fund

(i.e., Cremers and Petajisto (2009)), the greater the risk-shifting. Third, the

tenure of the manager mitigates risk-shifting arising from poor performance

in the previous year. Importantly, the introduction of these measures does not

change the impact of our key variable, Distance.

Finally, previous papers empirically estimates a convexity in the flow-

performance relation, which creates a tournament whereby managers of poorly

performing funds can increase their chances of winning by increasing their

portfolio volatility (i.e., Brown, Harlow, and Starks (1996), Chevalier and