If asked to name their 10 favorite sports heroes or movie stars, most people would have little trouble complying. However, if asked to list their 10 favorite professional money managers, the results would be far different. For those who could muster even a single name, the list might go no deeper than Peter Lynch (who is retired) and Warren Buffett. In short, the men and women working in the money management profession are virtually invisible.
Considering the amount of money at stake, this anonymity is quite surprising. A recent study by Goldman, Sachs & Company reported that by 1995, investment management companies controlled more than $6 trillion in mutual funds, pension plans, endowments and foundations.
Perhaps more disturbing is how little attention investors have paid to how money managers get compensated and whether these compensation schemes provide managers with the incentive to act in the investors' best interests.
Our research has concluded that certain money managers, due to the generally accepted method of compensation in the mutual fund industry, are likely to increase their portfolio's risk level in an effort to improve their chances of receiving higher bonuses. The altering of the risk level, one of a fund's most fundamental investment characteristics, might bolster a money manager's short-term goals, but it is almost certainly at odds with the long-term motivations of investors.
Previous research in the mutual fund industry has reached three important conclusions:
When selecting a fund, the primary attraction for investors is past investment performance, with the more successful funds able to attract the majority of new assets.
The rapid growth in the fund industry as a whole created a surprising result: funds that have been "winners" in the past see their assets under management grow while assets in "loser" funds do not shrink, but rather stay the same.
Finally, most funds receive as a management fee some percentage of those assets under management, typically about 25-hundredths to 60-hundredths of 1 percent.
Building on these findings, our own research has shown that compensation in the mutual fund industry -- both to the company as a whole and to the individual manager -- can be viewed as a tournament in which the top performers receive the largest amount of remuneration. Like participants in a tennis or golf tournament, mutual fund managers are paid, in part, based on how their performance compares with that of a set of peers, i.e., managers at similar funds.
What matters in any tournament, of course, is not a participant's absolute performance but his or her relative standing at the end of the contest. Indeed, a very typical compensation scheme in this business pays the manager a base salary as well as a bonus that depends on where his or her performance ranks in the relevant comparison "universe" at the end of the compensation period. This bonus might be structured as follows: 100 percent of base salary if the manager finishes in the top quartile of the universe, 50 percent if in the next highest quartile and zero percent if below the median.
Exhibit I illustrates the essential nature of this compensation arrangement. In particular, notice that the manager's compensation cannot be worth less than the base salary but will increase proportionally with the manager's relative performance after some point. In this example, the manager starts receiving a bonus when he or she generates a return for the fund's investors that is in the upper half of the peer group. Conversely, the manager whose performance falls below the median receives no bonus, whether finishing just below the mid-point or dead last in the rankings.
Indeed, the crucial factor is that any manager whose performance is below the median near the end of a compensation period (e.g., Manager L in the exhibit) has little to lose by increasing portfolio risk in an attempt to finish in the top half.