Fat and Happy? Evaluating Fund Manager Incentives

It's a question that has bedeviled fund investors for years--how do you know if the people running the fund have your best interests at heart? On Tuesday, Morningstar unveiled a new resource--Stewardship Grades* for mutual funds--that should go a long way toward getting investors to the bottom of that knotty question.

Morningstar analysts went to great lengths to evaluate management incentives as part of compiling the grades. Specifically, we sought to determine whether the structure of fund management's compensation and the depth of management's investment in fund shares sufficiently aligned its interests with those of fund shareholders. For example, is management rewarded for exceeding a relevant benchmark over a sufficiently long time horizon? Or does management's pay ebb and flow depending on the growth of the fund's assets, a metric that may better gauge marketing craft than investing acumen? Does management eat its own cooking by investing a substantial amount--defined as either more than $1,000,000 or more than one third of the manager's liquid net worth--in fund shares?

It's important to note that in seeking answers to these questions, Morningstar did not ask for the specific dollar amount of management's compensation. And the grading does not ignore financial planning concerns. For example, we would not expect a 30-year-old single-state municipal-bond fund manager to have a large chunk of money tied up in his fund. However, we believe that alternate measures, such as whether that same muni manager has a substantial sum invested across the fund complex, provide a viable way to measure a manager's conviction in the underlying asset management philosophy and process.

We believe these matters warrant a close look because they offer insights into how management is directing its efforts and whether it truly has a stake in the fund's success. For instance, managers whose compensation is tied to performance over short time periods could be tempted to take on excessive risks in order to maximize their bonuses.

Some firms did not provide complete details about management incentives. For example, Vanguard, Fidelity, AIM, and Eaton Vance were among the complexes that declined to provide specifics about the depth of management's investment in fund shares. Of course, these firms will soon have no choice in the matter, as the SEC recently approved rules that will require funds to disclose the structure of manager pay while expressing manager ownership of fund shares in specified dollar ranges (similar to the way fund director ownership of fund shares is disclosed). Thus, at the appointed time, Morningstar will canvass public filings and compile the relevant information, adjusting funds' Stewardship Grades as necessary. In the meantime, these funds are getting the credit they deserve in this area--none (or, at best, partial credit).

Still, scores of fund companies have furnished previously unavailable information on these topics. But what can be gleaned from the results that have poured in thus far? Here's a brief rundown of the key factors that influenced the way funds were scored:

Whether the compensation structure complements management's strategy.

•  Selected American (SLASX) got high marks for a compensation scheme that pays out bonus awards in fund shares, with those grants vesting only if the fund outperforms the S&P 500 Index and the fund's peers over the ensuing five years. This setup lends itself well to manager Chris Davis' low-turnover, Buffett-inspired, value-investing ethos.
   
• The structure of the compensation paid to managers of the Oak family of funds is unusual. Managers are paid a nominal base salary and receive bonuses on a quarterly basis that are based on two factors--the revenue Oak brings in over the period and firm founder Jim Oelschlager's assessment of each manager's performance. However, this quarterly payout approach seems at odds with the low-turnover, long-term-oriented strategy that is Oak's signature, partly explaining  White Oak Growth Stock Fund's (WOGSX) "fair" rating for manager incentives.
   
• One component of the bonus compensation methodology at  Longleaf Partners (LLPFX) measures the performance of individual stock picks in terms of how much the intrinsic value of the firm's business increases over the course of the year based on the free cash flow it generates. This ensures the managers are encouraged to pick companies that are creating value for shareholders, which is entirely consistent with Longleaf's absolute-value-geared strategy.

Whether the compensation structure emphasizes long-term, rather than short-term, investment objectives.

• We take a dim view of the management incentive structure that TIAA-CREF employs at offerings such as  TIAA-CREF Growth & Income Fund , where the bonus calculation skews heavily to the trailing one-year period.
   
• Putnam, on the other hand, has put a compensation system in place to better ensure that managers keep their eyes on the ball over the long haul. At funds such as  Putnam Voyager  , for instance, performance incentives generally account for 70% of compensation. The majority of the incentive goals are based on fund returns relative to peer groups over three- and five-year periods. Specific goals are to rank in the top third of those peer groups and avoid falling into the worst quartile, which should encourage managers to shoot for steady outperformance.

Whether the compensation structure mitigates, rather than heightens, potential conflicts of interest.

•  Ariel Fund's (ARGFX) bonus system is tied to firm profitability, which is often a thorny setup given that it's difficult for managers to effectively serve two masters--the management company and the fund shareholder. However, the fund's board sets up clear portfolio-management goals designed to ensure that the fund is managed consistently and that the manager is not taking on risks that are intended to drive the firm's profitability. The board evaluates such things as whether each fund's forward price/earnings ratio remains at a significant discount to appropriate benchmarks and whether turnover is kept at a reasonable level.
   
• Thirty percent of management's incentive compensation at  Calamos Growth Fund (CVGRX) is based on assets under management. We're leery of compensation based on asset size if there isn't a corresponding reduction in fees or if it might prevent the fund from closing before it becomes too unwieldy to maintain its style. These have been issues at Calamos from time to time, despite superior performance at many of its funds.

Whether the compensation structure is transparent.

• Some firms, such as William Blair and AIM Investments, provided only nebulous descriptions of the way they compensate managers. For instance, William Blair reported that compensation consists of a base salary, a discretionary bonus, and a share in the firm's overall profits, which merely scratches the surface. Similarly, AIM would offer no more than a platitudinous assurance that long-term investment performance is the most important of many variables in determining management compensation. Opaque disclosure of this sort doesn't pass the sniff test.
   
• By contrast, the Bridgeway fund family has been extremely forthcoming in offering details concerning not only the structure, but also the amount of management's compensation. Also uncommon is Bridgeway Capital Management's rule that the highest-paid employee can't earn more than 7 times the lowest-paid employee. This all but prohibits an excessive-pay package for the firm's executives.

Whether management has invested a significant portion of its net worth in fund shares.

• Oakmark declined to provide details regarding management's ownership of fund shares, a disappointment given that portfolio managers and the firm have been quick to advertise their longstanding belief that company managers should invest side-by-side with stock investors. Fund investors should expect the same from fund firms, in our view.
   
• Wally Weitz has more than one third of his liquid net worth invested across the various funds bearing his name, such as  Weitz Value Fund (WVALX).

* The Morningstar Fiduciary Grade for funds was renamed the Stewardship Grade for funds as of Feb. 7, 2005.