Don Phillips

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.

Shareholder interests typically have taken a back seat

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 to favor shareholder interests. 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.

Manager incentives lead to predictable results

When fund companies did include performance in managers’ evaluations, it was too often focused on the short term and downplayed or ignored the risks taken to achieve that performance. Fund companies knew that hot performance generated news coverage through quarterly leaders’ rankings and profiles. To be a top fund in a calendar year was certain to generate lots of press coverage. As the head of one major fund company once told me: “A management consultant told us that the way to move the needle in the no-load world was to have a fund rank in the top decile of its category for the year, so we aligned all our manager incentives to generate top-decile annual returns.” In the process, risk was discounted, costs downplayed, and any performance outside the calendar year ignored.

The results were entirely predictable: The firm got more top-decile results, but it also got more bottom-decile results. Their managers who were in the middle of the pack in November would take crazy risks to try to jump up the performance rankings before year-end, knowing that if they won, they’d get big bonuses—and if they lost, they’d get a clean scorecard on Jan. 1.

In pursuit of new shareholders, the firm incentivized managers to regularly blow up their funds and damage their long-term risk-adjusted performance—just what existing shareholders would not want. And the ultimate irony was that the new shareholders they did attract when successful were among the most fickle imaginable. They loved the fund when it was hot and abandoned it as soon as performance cooled.

New standards better support shareholder interests

Fortunately, the incentive situation has improved considerably in recent years. The Securities and Exchange Commission now requires fund companies in the United States to disclose the incentives embedded in their managers’ compensation. While these disclosures may not be widely read by shareholders, the fact that Morningstar, advisors, and consultants can access them as part of their stewardship assessment of a firm makes a huge difference.

Fund companies now are far more likely to link manager compensation to longer-term performance that often includes some sort of risk assessment. Moreover, it is now required that fund companies disclose in broad buckets the level of a manager’s own investment in the funds that they manage. While the industry fought this disclosure tooth and nail, there’s no better way to align manager and shareholder interests than to make sure the manager is also a shareholder.

How Morningstar ratings have impacted manager incentives

Finally, it’s worth considering the role that Morningstar’s ratings have played in manager incentives. The Morningstar Rating for funds, or star rating, has limitations. The stars are a grade on past performance—and past performance may not always be prelude to future returns, as many variables can change in a fund or in the investment environment in which the fund operates.

But as grades, the stars create incentives that are much better than the short-term leaders and laggards lists that they have displaced as evaluation tools. The stars are long-term-oriented, include a risk measurement, and are highly correlated with expenses. They thus encourage fund managers to keep costs down, to avoid wild risks, and to think long term. In short, they create precisely the incentives rational shareholders would want their fund managers to operate under.

Morningstar Analyst Ratings go even further in their attempt to create appropriate manager incentives. They are even more highly correlated with costs, putting more pressure on managers to lower fees. They also embed much of Morningstar’s stewardship work, rewarding management’s alignment with shareholder interests through investment in their own funds and favoring fund shops that have created better investor experiences by shunning faddish concepts that are easy to sell, but often blow up on shareholders.

Simply put, rational shareholders would far prefer their fund managers to aspire to be a Morningstar Medalist than to top the short-term performance derby.

Morningstar’s contribution to shareholder interests

At Morningstar, we’ve tried to make a positive contribution to shareholder interests by pointing the industry toward better behavior, lower fees, and more disclosure. In my opinion, we’ve had much success over the past 30 years in doing so. There’s still work to do, but we won’t stop trying to measure and reward those fund company behaviors that most benefit investors.

This blog post is adapted from an article that originally appeared in the December/January 2018 issue of Morningstar magazine. Read the full article.