Fund Managers and Performance Bonuses

Conflicting Principles "Well, you got your mules and you got your racehorses, and you can kick a mule in the ass all you want, and he's still not gonna be a racehorse."

Such was baseball manager Billy Martin's take on motivating mutual fund managers by paying them annual bonuses, based on the performances of their funds. Strictly speaking, it is true, Billy's subject was something other than fund managers, but in believing that motivation could take a worker only so far, he echoed the modern academic consensus on investment management. As fund managers cannot outguess the efficient markets, inspiring them through compensation schemes is pointless.

For those who believe in the strict version of the efficient markets, cost greatly matters for determining the quality of a fund. Turnover moderately matters. Not much else is important, including who runs the fund and how management is paid.

On the other hand, financial incentives do affect behavior. While variable-compensation plans have lost some of their luster in the academic community, due to concerns about unwanted side effects, there's no question that money motivates. Perhaps fund managers try harder when they can win a performance-based carrot. Or, perhaps, the mere existence of the carrot attracts better fund-manager applicants. Either way, many academics believe what hedge fund managers state--that shareholders get the quality that they pay for.

So, to an extent, there are two ideas at conflict. One is the principle that investment managers cannot improve their results, because the task is impossible. You might as well try harder at bailing out Lake Michigan with a bucket brigade. The other is the principle that money talks. Financial incentives have a direct, powerful effect on how people do their jobs.

So … who's right? Is Eugene Fama correct for believing that fund-manager mules can't become racehorses, or are the compensation researchers correct for arguing that money moves mountains?

The Research Says ... According to a recent paper, Portfolio Manager Compensation in the U.S. Mutual Fund Industry, it is the latter. The authors, three professors in as many continents (North America, Asia, Europe), find that fund managers who are paid bonuses based on their funds' returns "exhibit superior subsequent fund performance, especially when [their pay is linked] to performance over a longer time period. In contrast, alternative compensation arrangements, such as fixed salary, assets-based pay, or advisor-profits-based pay, are not associated with superior performance."

That surprised me. Not, of course, because I believe that the financial markets are strictly efficient. Although my columns tend to compliment indexing, I have also advocated for active management under the right circumstances (if sold at a low cost, run by good stewards, and possessing a strong long-term track record). There are opportunities, I believe, that can be exploited by particularly skilled managers.

However, I don't understand why these exceptions would be associated with annual bonuses. Performance is already everything to a fund manager. Bad numbers get a manager fired, while strong numbers attract new assets. If those new assets are substantial, the manager's salary will rise dramatically.

Plus, there are bragging rights. As evidenced by the millions of Americans who would do just about anything to win a fantasy football league, or who recruit fast 9-year-olds so that their third-grade soccer team wins the park-district title, there's a huge psychological payoff that comes from the public act of winning, regardless of whether there's profit to be made. (Warren Buffett enjoys outgaining other investment managers more than he does spending the money itself.) One would think that pride alone would suffice.

Apparently not; it's time to change my thinking. I will point out, though, that the findings are pretty weak. I do not disparage the size of the effect, which is about 50 basis points per year (after adjusting for risk and factor exposures, in the usual academic fashion). While half a percentage point each year is not a huge margin, it is comparable to the expected gain that comes from choosing a low-cost fund over a high-cost fund. Nobody calls that level of improvement insignificant. My concern instead is that most funds offer performance bonuses, 77% by the professors' count. Thus, the paper studies not the presence of an unusual factor, but rather the absence of a common factor.

That threatens the professors' interpretation. While there's no denying the study's results, the ubiquity of performance bonuses does lead to an explanation that the professors did not offer. Perhaps it is not the case that the bonuses cause existing employees to become better investors, or that the bonuses attract superior outside talent. Perhaps instead it is the lack of such bonuses that matters. Perhaps their absence signals that a fund company is second-rate. As with a substandard 401(k) plan, or poor health-care insurance, a salary offer that falls below the industry's best practices might lead to dispirited workers, as well as the inability to recruit top candidates.

A Slightly Faster Mule Regardless of the reason, the two mules move at different speeds. It appears that if you kick a fund-manager mule, he responds by becoming a slightly faster mule. That's not as good as becoming a racehorse ... but it's something. Thus, this paper refutes the strictest interpretation of the efficient-markets theory, as sometimes espoused by professors and index-fund advocates. It suggests that there are more aspects to judging a fund's quality than merely finding its expense ratio and seeing its portfolio turnover.

Counterpoint Morningstar's Gregg Wolper takes issue with the conclusion of Tuesday's column, which inserts a few grains of salt into areas of active management's success. I wrote:

"For much of the past quarter century, actively managed overseas stock funds and intermediate-term bond funds have competed well against their passive rivals. However, a note of caution is needed. Unlike with U.S. stock funds, where the active funds in aggregate look much like the market benchmarks, these categories can diverge significantly. For example, few intermediate-bond managers invest as heavily in Treasuries as does the Barclays Aggregate. Thus, it's difficult to tease out how much of active management's better results are because of ongoing factors, as opposed to the temporary assistance of a benchmark mismatch."

Writes Gregg:

To me, this argument doesn't fly. When active managers imitate the benchmark, they're closet indexers. When they don't imitate the benchmark, then it must be a mismatched benchmark. Well, if these are your ground rules, then by definition active managers can never win. It's kind of comical.

Here's my interpretation: The foreign and bond managers beat the index ... by being active managers. These were common, widely used indexes, and the managers beat them. No reason to make excuses for the passive side.

Think of it this way: If the passive bond funds had won because Treasuries massively outperformed, how many people would say the results need to be taken with a grain of salt because they were following a weird, Treasury-heavy index? Not many. It would just be used as further evidence against active management.

Fair enough. Sometimes readers should get the final say.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.