What's the best incentive scheme for fund managers?

Here's an argument hedge fund marketers make to tout hedge funds' superiority over mutual funds. They point out that unlike mutual fund managers, who are paid solely based on assets under management, hedge fund managers also receive incentive compensation. The typical hedge fund compensation scheme is 2/20, or 2 percent of assets under management plus 20 percent of profits (or profits above some benchmark such as the rate of return on one-month Treasury bills).

The argument then goes: Relative to hedge fund managers, mutual fund managers have more incentive to minimize tracking error (minimizing the risk of underperformance) than to generate alpha (outperformance).

This argument might hold if better-performing mutual funds didn't benefit from increased flow of assets from investors. To see if the "conventional wisdom" about incentive pay is correct, the authors of the study "Mutual Fund Outperformance and Growth," published in the second quarter of 2014 edition of the Journal of Investment Management, examined nearly 30,000 mutual funds from Dec. 1, 1985 to Sept. 30, 2012.

The authors found that mutual fund managers who generate excess returns over benchmarks are consistently rewarded with asset growth, which boosting their compensation. Specifically, they found that a fund that earns 10 percent more than the size-weighted average of its peers in the same style group will, on average, realize an extra 5 percent of asset growth in the following year.

This pattern of future excess asset growth of about half the rate of current excess returns holds for all categories, with only two exceptions: small funds (under $250 million of assets) of any style and large fixed-income funds with more than $2 billion of assets.

Thus, we can conclude that mutual fund managers do have incentives to generate alpha (outperform).

The problem for investors is that their performance-chasing actions show they believe past performance predicts future performance. Unfortunately, the evidence demonstrates that for mutual funds, as well as hedge funds, there's basically no persistence of performance beyond the randomly expected. The sole exception: Poorly performing funds with high expenses do exhibit persistently poor performance. Even Morningstar concluded that the best predictor of future performance is expenses, the lower the better.

Why winning funds advertise

Investors have another problem related to their belief in "encore" performance. Have you ever seen an ad for a mutual fund that advertises its poor track record? Of course not. The ads are a form of selection bias -- you only see them for the winners, never the poor performers.

Why do funds advertise their winning records? The presumption is that investors will extrapolate past success into the future -- despite the warning/disclaimer that the SEC requires reminding investors that past performance isn't an indicator of future performance.

In their study, "Truth in Mutual Fund Advertising: Evidence on Future Performance and Fund Flows," published in the April 2000 issue of the Journal of Finance, Prem C. Jain and Joanna Shuang Wu examined the performance of 294 U.S. equity mutual funds that advertised in Barron's or Money magazine. They measured the performance of mutual funds one-year prior to the first ad date and one year after.

Given the bias that funds wouldn't advertise poor performance, the advertised funds not unexpectedly performed well above average prior to the ad date. The average one-year pre-advertised return of the 294 funds was almost 6 percent higher than the return of comparable funds during the period from July 18, 1994, to June 30, 1996. The returns of the advertised funds were also 1.8 percent above the return of the S&P 500.

In the post-ad period, however, the same funds returned 0.8 percent below the return of all comparable funds. The advertised funds also underperformed the S&P 500 by almost 8 percent a year. Not surprisingly, the study also found that advertised funds attracted significantly greater investments than similar funds in the post-ad period, despite the forward-looking results basically being a random event.

The study considered the possibility that the poor post-advertising performance might have been caused by manager turnover. During the period, 246 funds had no manager turnover. The study found no difference in performance between the funds that experienced turnover and those that didn't.

The authors concluded that there was no persistency in fund performance and that past performance cannot be attributed to the fund managers' skills. The other conclusion we can draw is that past fund performance combined with advertising does generate investor cash flows. This provides further evidence that mutual fund managers are incented to generate alpha.

How agency risk can burn investors

While we're on the subject of fund manager incentives, here's another important issue, one that very few individual investors are aware of, related to the incentive pay structure of most hedge funds. The problem is called agency risk.

The compensation structure of hedge funds is geared in a way that much, if not most, of the reward for managers occurs in the form of incentive pay (usually 20 percent of profits). Thus, investors take all the downside risk, but do not participate fully in the upside.

Agency risk occurs when a manager approaches the end of a year and has failed to reach the benchmark level above which incentive compensation is paid. This presents a clear conflict of interest in the form of unequal incentives. If the manager takes large risks in an attempt to beat the benchmark and wins, he or she will receive incentive pay.

However, if the manager fails, he or she loses nothing and still receives the minimum fee. This creates an incentive for the fund manager to take on greater risk in a game of "I Can Win, But I Never Lose."

What has happened in the past, leading to the eventual demise of several hedge funds, is that a hedge-fund trader places a big bet that loses. He or she then decides to double up in an effort to earn back the loss. If the market keeps going against the trader, he or she doubles up again until the "game" ends.

Sunk by the "high water" benchmark

There's a second type of agency risk. Most hedge funds have a clause that "protects" investors with what is known as a "high water" benchmark that works in the following manner. After a year of negative performance, the fund cannot collect its incentive pay unless it first "makes up" the negative performance.

For example, if a fund loses 10 percent in the first year, its incentive pay in the second year will be calculated only on the amount earned above the high watermark. Due to the effect of compounding, the fund would have to earn 11.1 percent in the second year to return to the high watermark.

The problem for investors is twofold. First, the same type of agency risk just discussed becomes an issue. To reach the high watermark and earn the incentive compensation, the fund manager may be tempted to take on greater risk than investors anticipate.

The second problem is that after a bad year or two, when the chances of earning any incentive pay become small, the fund manager has the right to shut down the fund, returning all assets to investors. Thus, the high watermark that investors counted on never comes into play. The hedge fund manager leaves and starts up a new fund, with no high watermark to overcome.

Which incentive structure is better for investors?

The bottom line is that because cash flows do follow performance, the best way for mutual fund managers to increase their compensation is to outperform their benchmarks. That provides them with the incentive to generate alpha. Yet, because mutual funds don't have the same profit-sharing incentive that hedge funds have, mutual fund investors don't court the agency risk investors in hedge funds take on.

The mutual fund structure is far better for investors.