The mantra of management is that you get what you measure. If you want more employee face time in the office, measure their entrances and exits. If you want greater safety in the workplace, measure the number and severity of accidents. It stands to reason; people respond to the pressures and incentives placed upon them. Mutual fund managers, of course, are no different. If you incent them to generate high yields, they will stretch for added income. If you reward short-term performance, but ignore risk, they will shoot for the moon.
The problem in the mutual fund world is that for years these incentives were applied for the apparent benefit of the asset manager and not necessarily for the benefit of fund shareholders. It was commonplace to base portfolio manager compensation on the size, rather than the performance, of the fund they were managing. Bigger rewards for those shouldering a bigger load make sense within the halls of the management firm: A bigger fund is a bigger profit source and all of the firm’s employees know that. But fund shareholders don’t care about fund company profits, they care about their own experience. They want their portfolio manager researching securities, not schmoozing with brokers, but the manager was often incentivized to do just the opposite. While better performance should in time bring more assets, that’s a tenuous link that may take years to realize. Getting a broker to sell more shares today has an immediate impact.