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How are individual portfolio managers compensated in the US mutual fund industry, and why does it matter for your wallet?

GAINESVILLE, Fla. –   Millions of American investors across the nation have long trusted asset management companies, like Fidelity Investments and The Vanguard Group, to manage their mutual fund investments. In fact, in 2017 almost half of all U.S. households (about 56 million) owned mutual funds. In exchange for managing their funds, investors are charged a management fee by investment companies. While management fees are an understood exchange between investors and investment companies, there is a second exchange that, until now, wasn’t open for public view, but still affects investor returns.

Hidden in the walls of the investment company, portfolio managers have the daily responsibility of making investment decisions that affect the performance of those 56 million Americans’ mutual fund investments. As employees of trusted investment companies, portfolio managers are expected to make the best decisions so that the mutual funds they manage produce the strongest returns. However, as employees, what incentives do investment companies use to persuade portfolio managers to do this?

Yuehua Tang

Dr. Yuehua Tang

Some argue that performance-based compensation plans, like fulcrum fees, which rise when the fund performs well and decline when the fund does not, are the best way to incentivize portfolio managers and should be used by more investment companies to satisfy investor requests for fair management fees. In fact, according to new research from Warrington College of Business Assistant Professor of Finance Yuehua Tang, the majority of portfolio managers (about 80 percent) are indeed compensated based on fund performance, but not in the same way across all institutions. Tang and his colleagues, Linlin Ma of Northeastern University and Juan-Pedro Gómez of IE University, hand-collected the compensation structure of portfolio managers from over 4,500 actively managed mutual funds in the U.S. from 2006-2011 in order to analyze how portfolio managers are compensated.

Their research shows that while the majority of portfolio managers are compensated based on fund performance, there is significant diversity in those compensation structures across investment companies. Furthermore, their analysis on what drives heterogeneity in compensation contracts suggests that performance-based bonuses and other forms of deferred compensation for portfolio managers are mainly used to mitigate potential conflicts of interests between investment companies and investors. For example, they observed that performance-based compensation and bonuses are more frequent among portfolio managers affiliated with a bank or broker, to signal to investors that they are not just interested in serving their own businesses’ needs, but those of the customer. They find this is similar among investment companies with a more dispersed clientele: their bonuses are more sensitive to fund performance than those in more specialized advisors, like those in mutual funds.

Overall, Tang and his colleagues conclude that the significant differences among compensation plans for portfolio managers are understandable based on the differences among mutual fund families and their needs. Because of this, they conclude, there is no “one-size-fits-all” compensation option for portfolio managers that results in better performance outcomes for investors. Therefore, compensation plans should also not be regulated based on a “one-size-fits-all” approach.

So, what does this mean for your wallet if you’re one of those 56 million American households that invest in mutual funds? Tang and his colleagues recommend that you shouldn’t worry about how investment companies are compensating their portfolio managers, as their executives will decide what’s best for their company’s individual needs. Instead, you should continue to focus on achieving the best after-tax performance of your investments: choose a company with low management fees and a buy-and-hold approach in choosing no-load funds.

This research is forthcoming in the Journal of Finance. Check out Tang, Ma and Gómez’s full research here.