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

• Author: LINLIN MA,JUAN‐PEDRO GÓMEZ,YUEHUA TANG
• Date: 01 April 2019
• DOI: http://doi.org/10.1111/jofi.12749
• Published date: 01 April 2019

THE JOURNAL OF FINANCE •VOL. LXXIV, NO. 2 •APRIL 2019

Portfolio Manager Compensation in the U.S.

Mutual Fund Industry

LINLIN MA, YUEHUA TANG, and JUAN-PEDRO G ´

OMEZ∗

ABSTRACT

We study compensation contracts of individual portfolio managers using hand-

collected data of over 4,500 U.S. mutual funds. Variations in the compensation struc-

tures are broadly consistent with an optimal contracting equilibrium. The likelihood

of explicit performance-based incentives is positively correlated with the intensity

of agency conflicts, as proxied by the advisor’s clientele dispersion, its affiliations in

the financial industry, and its ownership structure. Investor sophistication and the

threat of dismissal in outsourced funds serve as substitutes for explicit performance-

based incentives. Finally, we find little evidence of differences in future performance

associated with any particular compensation arrangement.

MUTUAL FUNDS ARE PROFESSIONALLY MANAGED investment vehicles that pool

money from many investors to purchase securities such as stocks, bonds, and

money market instruments. According to the Investment Company Institute,

∗Linlin Ma is with Peking University HSBC Business School. Yuehua Tang is with the War-

rington College of Business at the University of Florida and is the corresponding author (yue-

hua.tang@warrington.ufl.edu). Juan-Pedro G´

omez is with IE Business School, IE University.This

paper has benefited from comments and suggestions from Kenneth Singleton (the Editor), two

anonymous referees, Vikas Agarwal, Andrew Alfold, Jonathan Berk, Gennaro Bernile, Jules van

Binsbergen, David Brown, Andrea Buffa, Jeff Busse, Mark Chen, Steve Dimmock, Roger Edelen,

Alex Edmans, Richard Evans, Olubunmi Faleye, Fangjian Fu, Yaniv Grinstein, Martin Gruber,

Jennifer Huang, Jiekun Huang, Lixin Huang, Sheng Huang, Wei Jiang, Jayant Kale, Omesh Kini,

Marc Lipson, Roger Loh, Garen Markarian, Massimo Massa, Pedro Matos, Andy Naranjo, Mitchell

Petersen, Jeff Pontiff, Jonathan Reuter, Jay Ritter,Michael Ryngaert, Linda Schneider, Clemens

Sialm, Juan Sotes-Paladino, Kevin Spellman, Anand Srinivasan, Laura Starks, David Stolin, Neal

Stoughton, Dragon Tang, Melvyn Teo, Russ Wermers, Baozhong Yang, Tong Yao, Hayong Yun,

Rafael Zambrana, and Fernando Zapatero. We thank seminar and conference participants at the

2015 CICF, 2014 Finance Down Under Conference, 2015 FIRS Conference, 2018 GSU CEAR-

Finance Conference, 2014 Jerusalem Finance Conference, 2013 SFS Cavalcade, 2013 Singapore

Scholars Symposium, 2015 WFA, Nova SBE, ESSEC Business School, Georgia State University,

IE Business School, National Bank of Serbia, NYU, Renmin University of China, University of

Florida, and UNC Chapel Hill. We are grateful to ˇ

Luboˇ

sP

´

astor, Robert Stambaugh, and Luke

Taylor for CRSP and Morningstar merged mutual fund data. We also thank Changhyun Ahn,

Dhruv Boruah, Sangho Lee, Osama Mahmood, Shai Shemesh, Jinfei Sheng, and Qinxi Wu for

excellent research assistance. Tang acknowledges research support from the Ministry of Educa-

tion of Singapore (Grant No. C207MSS13B002); G´

omez acknowledges support from the Spanish

Ministry of Economy and Competitiveness (Grant No. ECO2014-53022-R) and the Bank of Spain.

G´

omez thanks NYU Stern and Nova SBE for their hospitality. A significant portion of the paper

was conducted when Ma was with Northeastern University. The authors have read the Journal of

Finance’s disclosure policy and have no conflict of interest to disclose.

DOI: 10.1111/jofi.12749

587

588 The Journal of Finance R

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 in-

centives, however, the literature has focused primarily on the design of the

advisory contracts between fund investors and investment advisors (i.e., asset

management companies).1Thus, little is known about the compensation con-

tracts of the actual decision makers—individual portfolio managers hired by

advisors to manage the fund portfolio on a daily basis.

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).2

For instance, mutual funds need to disclose whether portfolio manager com-

pensation 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 bench-

mark used to measure performance and to state the length of the period over

which performance is measured. In this paper, we analyze this mandatorily dis-

closed information to enhance our understanding of managerial incentives in

the U.S. mutual fund industry and to test predictions from models on portfolio

delegation and contract design.

We hand-collect 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 to 2011. We uncover the following stylized facts. First, almost all of

our sample 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 10 years, with the average evaluation window equal to 3 years. Third, we

find that, for about half of 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, we find that deferred compensation is present in

almost 30% of the sample funds.

Incentives based on fund performance, AUM, and the advisor’s profits are

not necessarily mutually exclusive. Out of the observations that include vari-

able compensation, 36.1% offer managers a bonus based only on investment

performance, 14.5% offer a bonus based only on the advisor’s profits, and only

0.9% offer a bonus based exclusively on AUM. For the remaining sample funds,

1See, for example, Starks (1987), Grinblatt and Titman (1989), Golec (1992), Tufano and Sevick

(1997), Coles, Suay, and Woodbury (2000), Das and Sundaram (2002), Deli (2002), Elton, Gruber,

and Blake (2003), Golec and Starks (2004), Dass, Massa, and Patgiri (2008), Massa and Patgiri

(2009), and Warner and Wu(2011).

2See SEC Rule S7-12-04, Disclosure Regarding Portfolio Managers of Registered Management

Investment Companies, http://www.sec.gov/rules/final/33-8458.htm.

Portfolio Manager Compensation in the U.S. 589

managers receive some combination of the three types of bonus. For instance,

in 11.3% of cases managers receive all three types of bonus simultaneously.

These stylized facts contrast with the evidence on advisory contracts in the

United States, where AUM-based advisory fees are the predominant structure

and performance-based compensation is rarely observed (e.g., Elton, Gruber,

and Blake (2003)).

Even though the SEC does not require funds to disclose the relative weights

of potential bonuses (i.e., maximum bonus opportunity) and base salary, half

of our sample funds voluntarily release such information. While some funds

report a quantitative ratio of bonus over base salary, others describe it in qual-

itative terms. Among the funds that disclose quantitative information, about

35% of them report a bonus-to-salary ratio greater than 200%; about 70% report

a ratio greater than or equal to 100%. For those funds that disclose qualitative

information, about half 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. These findings suggest that variable bonus incentives play

a significant role in portfolio manager compensation in the U.S. mutual fund

industry.

Having documented compensation patterns at the descriptive level, we next

study the determinants of compensation structures of portfolio managers. An

extensive theoretical and empirical literature since H¨

olmstrom (1979) studies

managerial compensation contracts, especially performance-based incentives.

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 advisor-, manager-, and fund-level variables proposed in the

literature. In particular, our empirical analyses test three broad hypotheses.

Our first hypothesis states that performance-based contracts are costly to im-

plement and emerge as optimal only when agency conflicts are severe enough

(e.g., Starks (1987), Grinblatt and Titman (1989), Li and Tiwari (2009), and

Cuoco and Kaniel (2011)). We find strong and robust support for this predic-

tion. 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 (e.g., Gaspar, Massa, and Matos (2006)); (ii) the advisor

is affiliated with a bank or a broker-dealer and hence is more prone to make

decisions that enhance the value of the bank or the broker rather than fund

performance (e.g., Ferreira, Matos, and Pires (2018)); or (iii) the portfolio man-

ager is not the founder or a significant stakeholder of the advisor, that is, in

the absence of the incentive alignment induced by ownership (e.g., Jensen and

Meckling (1976)). We find similar evidence regarding deferred compensation.

In particular, compensation is more likely to be deferred when the intensity

of agency conflicts is higher. This is consistent with the interpretation of de-

ferred compensation as an instrument that alleviates the myopic behavior of

portfolio managers and aligns their long-term objectives with those of fund

investors.

Our second hypothesis states that alternative mechanisms make explicit

contract incentives redundant. We consider the following four mechanisms: (i)