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The Impact Of Rewarding Fund Managers For Outperforming The Market

Fund managers are sometimes rewarded for performing better than their peers or ”beating the market”. New research by Dr Sandeep Kapur and Professor Allan Timmerman, published in the October 2005 issue of the
Economic Journal, finds that such ”relative performance evaluation contracts” may not be necessary: the same outcome can be achieved by rewarding managers according to their absolute performance. What’s more, the researchers find, contracts based on relative performance can have real effects, notably inducing managers to tilt towards holding more risky assets. The increased delegation of investment decisions to fund managers and the growing use of relative performance-based contracts may have contributed to the observed lowering of the ”equity risk premium” (which investors demand to hold risky assets) in recent years.

The explosive growth of the asset management industry in the 1990s was accompanied by a growing trend towards performance-based remuneration for fund managers. As stock markets performed well over this period, the
absolute performance of a fund was not a reliable measure of managers” stock-picking ability. Rewarding fund managers on the basis of their relative performance seemed attractive: it provided incentives for fund managers to perform well while stripping away the uncertainty common to all funds.

This study examines contracts that allow rewards to vary with both absolute and relative performance and may also include a fixed component (say, a ”retainer”). The contracts analysed are symmetric: they penalise underperformance just as much as they reward outperformance. Such symmetry has been mandatory for US mutual funds. The impact of performance-based contracts on portfolio choices of fund managers has been studied before. This research extends this to study the ”equilibrium” consequences of those choices, and finds that the aggregate outcome of the impact on individual portfolio choices may be somewhat surprising:
• Fund managers’ portfolio choices typically undo the incentive effects of tying rewards to relative performance.
• Put differently, if owners of funds can design the managers” remuneration contracts without any restrictions, they can achieve the same outcome through a contract that rewards fund managers purely on the basis of their absolute performance.
• But investors may not always be able to choose optimal contracts. For example, in some situations, ”optimality” may require that the fixed component of the delegation contract is negative. A negative retainer implies that fund managers bid for the right to manage funds rather than get a retainer, which, in practice, is not very common.
• In such situations, contracts based on relative performance have real effects. In particular, they induce fund managers to tilt towards holding more risky assets.
• If delegation of investment to better informed fund managers lowers the risk associated with any given holding of risky assets, and if the use of relative performance-based contracts compounds the willingness to hold risky assets, there should be an impact on the ”equity risk premium” that investors demand to hold risky assets.
• In a series of numerical examples using plausible values of parameters, the researchers find that these effects could lower the equity premium by as much as 1-4%. Other empirical studies have found that the equity premium has declined in recent years. This study suggests possible channels that may have contributed to this decline.

”Relative Performance Evaluation Contracts and Asset Market Equilibrium” by Sandeep Kapur and Allan Timmerman is published in the October 2005 issue of the Economic Journal. Sandeep Kapur is at Birkbeck College, London. Allan Timmerman is at the University of California, San Diego.

Allan Timmermann

Associate editor | University of California, San Diego

Sandeep Kapur

020-7631-6405 | s.kapur@bbk.ac.uk