PROPER MOTIVATION OR ADVERSE INCENTIVES?
On the surface, there is little to suggest that establishing a positive linkage between the investor's return and a manager's reward is improper. After all, if every manager received the same fixed salary no matter what their investment performance, why would anyone ever strive to produce better than average returns? It is the anticipation of a superior reward that provides managers with the incentive to take the risks necessary to excel for their clients.
Nevertheless, our research has shown where conflict might arise in this type of compensation structure. Specifically, we have found that toward the end of a compensation tournament, managers most likely to finish below the median tend to increase their portfolio's risk level in an effort to improve their overall standing. As we noted, this altering of a crucial investment characteristic may be in the manager's short-term interest, but inevitably it conflicts with the long-term goals of investors.
To understand better why such risk manipulation occurs, consider this example: Suppose there are two investment managers competing against each other and that at the end of the current compensation tournament -- which by tradition coincides with the calendar year -- one will be declared a winner and the other a loser. Both managers will then be compensated according to their final status, with only the winning manager receiving a year-end bonus.
Midway through the tournament, Manager L finds that her performance is lagging behind that of Manager W; the two managers can be labeled interim loser and winner, respectively.
In this scenario, it is clear that Manager L has a strong incentive to increase the risk of her portfolio. If she is successful in increasing her return performance beyond that of Manager W, she will receive additional compensation. If not, her pay will remain what it is currently projected to be anyway. (Of course, if things were to get totally out of hand, and the increased risk produced terrible losses, Manager L might well face termination.)
On the other hand, Manager W might actually reduce portfolio risk in an effort to preserve his lead by "locking in" his present return level.
To document this behavior, we analyzed the performance of 334 growth-oriented mutual funds during the 12-year period from 1980 through 1991. Taking each year in this sample as a separate tournament, we considered two different aspects of a fund's performance: the fund's cumulative return between January and July, and the ratio of the fund's risk level (as measured by the standard deviation of returns) after the midyear point compared with its first-half risk level.
Each fund was then placed into the appropriate cell in a simple 2 x 2 grid according to whether it was a midyear winner or loser (i.e., cumulative return above or below the median) and whether its subsequent risk change was above or below the median for all funds.
As shown in Exhibit II, our hypothesis suggests that midyear losers should be more likely to increase risk while midyear winners are more likely to decrease risk (or increase risk by a far smaller amount).
We divided the study into three periods: the entire 12-year period, the most recent 6-year subperiod and the most recent 3-year subperiod. While Exhibit III shows the presence of the anticipated risk-altering behavior over the entire 12-year time frame, it was clearly much stronger in the last few years.
This means that the effects of the adverse incentives built into the compensation arrangement in the mutual fund industry are becoming increasingly more pronounced. Not surprisingly, this trend is consistent with the business and financial media's increased focus on relative fund performance, a change in emphasis that began in the mid-1980's.
Perhaps the most important implication of our research is the possibility that the current tournament structure in the mutual fund industry truly does provide adverse economic incentives to fund managers. By focusing so much attention on relative return performance, the industry unknowingly may be encouraging managers to alter fund objectives from a long-term to a short-term perspective.
Thus, within the current compensation environment, it appears that managers with the poorest midyear performance tend to act in a manner consistent with their own best interest and not necessarily in the best interest of the investors. Further, increased competition in the fund industry and the more widespread dissemination of information about relative fund performance appear to have intensified this trend.