Fund managers are sometimes rewarded for performing better than their
peers or ‘beating the market’. New research by Dr Sandeep Kapur and
Professor Allan Timmerman, published in the October 2005 issue of the
Economic Journal, finds that such ‘relative performance evaluation contracts’
may not be necessary: the same outcome can be achieved by rewarding
managers according to their absolute performance.
What’s more, the researchers find, contracts based on relative performance
can have real effects, notably inducing managers to tilt towards holding more
risky assets. The increased delegation of investment decisions to fund
managers and the growing use of relative performance-based contracts may
have contributed to the observed lowering of the ‘equity risk premium’ (which
investors demand to hold risky assets) in recent years.
The explosive growth of the asset management industry in the 1990s was
accompanied by a growing trend towards performance-based remuneration
for fund managers. As stock markets performed well over this period, the
absolute performance of a fund was not a reliable measure of managers’
stock-picking ability. Rewarding fund managers on the basis of their relative
performance seemed attractive: it provided incentives for fund managers to
perform well while stripping away the uncertainty common to all funds.
This study examines contracts that allow rewards to vary with both absolute
and relative performance and may also include a fixed component (say, a
‘retainer’). The contracts analysed are symmetric: they penalise
underperformance just as much as they reward outperformance. Such
symmetry has been mandatory for US mutual funds.
The impact of performance-based contracts on portfolio choices of fund
managers has been studied before. This research extends this to study the
‘equilibrium’ consequences of those choices, and finds that the aggregate
outcome of the impact on individual portfolio choices may be somewhat
surprising:
• Fund managers’ portfolio choices typically undo the incentive effects of
tying rewards to relative performance.
• Put differently, if owners of funds can design the managers’
remuneration contracts without any restrictions, they can achieve the
same outcome through a contract that rewards fund managers purely
on the basis of their absolute performance.
• But investors may not always be able to choose optimal contracts. For
example, in some situations, ‘optimality’ may require that the fixed
component of the delegation contract is negative. A negative retainer
implies that fund managers bid for the right to manage funds rather
than get a retainer, which, in practice, is not very common.
• In such situations, contracts based on relative performance have real
effects. In particular, they induce fund managers to tilt towards holding
more risky assets.
• If delegation of investment to better informed fund managers lowers the
risk associated with any given holding of risky assets, and if the use of
relative performance-based contracts compounds the willingness to
hold risky assets, there should be an impact on the ‘equity risk
premium’ that investors demand to hold risky assets.
• In a series of numerical examples using plausible values of
parameters, the researchers find that these effects could lower the
equity premium by as much as 1-4%. Other empirical studies have
found that the equity premium has declined in recent years. This study
suggests possible channels that may have contributed to this decline.
ENDS
Notes for editors: ‘Relative Performance Evaluation Contracts and Asset
Market Equilibrium’ by Sandeep Kapur and Allan Timmerman is published in
the October 2005 issue of the Economic Journal.
Sandeep Kapur is at Birkbeck College, London. Allan Timmerman is at the
University of California, San Diego.
For further information: contact Sandeep Kapur on 020-7631-6405 (email:
s.kapur@bbk.ac.uk); Allan Timmerman +1-858-534-4860 (email:
atimmerm@ucsd.edu); or RES Media Consultant Romesh Vaitilingam on
0117-983-9770 or 07768-661095 (email: romesh@compuserve.com).