The Markets May 23, 2014

Are Mutual Fund Managers Driven to Perform?

A recent analysis from Gerstein Fisher challenges the notion that mutual fund managers don't have as much incentive to outperform as peers running other fund types.
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A paper from the investment services provider shows a mutual fund that earns 10% more than the size-weighted average of its style group in one year will, on average, experience a 5% excess asset growth in the subsequent year—mainly by attracting new investors. The findings were consistent across nearly all fund styles and sizes, researchers explain, except for startup funds and very large fixed-income vehicles.

Researchers say this result debunks the common notion that mutual fund managers aren’t driven to outperform because they are typically compensated solely based on asset levels in their fund—with no performance incentives per se. But as the data shows, outperforming mutual fund managers will, in fact, see their assets under management grow as more investors pile into the fund, meaning they have a financial interest in seeing their fund succeed.

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Contributors to the paper include Gregg Fisher and Zakhar Maymin, of Gerstein Fisher, and Philip Maymin, of New York University. The team consulted data from the Center for Research in Security Prices Survivor-Bias-Free U.S. Mutual Fund Database both for monthly fund values and categorization information, utilizing performance data ranging back to December 1985. Fifty-four funds styles were used in the analysis.

One important insight gleaned from the effort is that the amount a fund can expect its future assets to grow as a function of its current outperformance depends heavily on the fund style and size, Gregg Fisher, CIO for Gerstein Fisher and portfolio manager of the Gerstein Fisher Funds, tells PLANSPONSOR.

Overall, across all fund styles, an outperforming mutual fund can expect future asset growth to increase if its current size is between $250 million and $2 billion, Fisher explains. The peak of the positive impact of current outperformance on future asset growth comes around $250 million, when the “coefficient of growth” derived through regression analysis is 0.5. As the researchers explain, a coefficient of 0.5 in this context means a fund outperforming its benchmark by 10% can expect additional asset growth relative to its benchmark of 5% over the subsequent year, net of future excess returns.

Fisher says his firm decided to conduct the research after years of hearing questions from clients about which incentive model is preferable—the asset-based fees typical of mutual funds or the performance-bonus arrangement more frequently used in hedge funds. Clients buying mutual funds are often worried the fund manager will not be driven to outperform his benchmark, Fisher says.

"I think one of the overall lessons here is that good people and good managers will do good things, and bad people and bad mangers will do bad things," Fisher says. "We found there is really no inherent advantage from one incentive model or another."

Fisher is quick to add that the overall picture may obscure the different results observed within different fund styles. For example, the impact of outperformance on equity fund inflows are significant from $250 million in assets and above, continuing to be significant even above $2 billion, with a coefficient on average of about 0.5. remaining in place far beyond $250 million in assets. For fixed-income funds, on the other hand, current outperformance is only mildly significant for funds with $250 million to $2 billion in assets. This class shows a much lower coefficient of growth, at approximately 0.2, according to the researchers.

Mixed fixed-income and equity funds offer a combination of the two, Fisher says, with significance across all asset sizes above $250 million and an average coefficient slightly higher than the equity funds. Researchers say other fund styles are roughly similar to mixed fund styles, with the important difference that they start showing significance at a minimum asset size of $500 million.

According to the authors, these results should be helpful to plan sponsors and financial advisers when deciding whether to pursue or employ potential alpha-generating strategies. They also suggest, Fisher says, that it's probably not necessary for retirement plan investors to fret about the motivations of the managers running their investment options. After all, no fund will benefit from poor performance, he says.

Fisher says the research could also go a long way to dispel the assumption that fund managers with performance-based incentives will be more engaged than managers compensated through fees based only on asset level. Fisher says this arrangement has historically suggested to some that mutual fund managers are less inclined to pursue innovative strategies that may generate excess return.

Not so, the researchers conclude. They argue the excess future inflows observed for outperforming funds imply that mutual fund managers should always prefer to increase their alpha, even if they are already beating their own benchmarks or peers. In other words, better performance leads to more assets, regardless of fund type, which leads in turn to higher manager compensation.  

“In particular, we have shown using a clean historical mutual fund database that an excess return in one year relative to one’s peers leads to additional excess asset growth in the subsequent year,” the team writes. “As a rule of thumb, the future excess asset growth will be about half as much as the current excess return.”

More on the research is available here.

Compliance May 23, 2014

Reforming Social Security to Increase Retirement Income

Witnesses at a Senate hearing discussed Social Security reforms that could boost potential retirement income for workers.
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During the hearing, “The Strengthening Social Security to Meet the Needs of Tomorrow’s Retirees,” before the U.S. Senate Committee on Finance’s Subcommittee on Social Security, Pensions and Family Policy, Teresa Ghilarducci, chair of the Economics Department at the New School for Social Research in New York, New York, noted low and middle-income individuals are particularly vulnerable to low levels of retirement readiness, pointing out that these individuals are “more likely to take loans from their 401(k) or withdraw monies from their 401(k) or individual retirement account (IRA).” Ghilarducci also noted workers in these income ranges also tend to have more conservative investment portfolios that produce lower returns.

Age also seems to play a role in low levels of retirement readiness, with younger workers (ages 20 to 39) more likely to cash out their retirement balance than their older counterparts. “Forty percent of these workers cash out to a large loss,” she said.

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Maya Rockeymoore, president and CEO of the Center for Global Policy Solutions in Washington, D.C., testified that she foresees a greater dependence on Social Security for retirement income, with “a majority of the nation’s workers continuing to rely on Social Security for much of their retirement income well into the future,” while at the same time the program’s benefits remain modest. Efforts to strengthen Social Security should not only focus on the program’s solvency, she said, but also consider how to increase the adequacy of benefits for vulnerable populations.

To that end, Rockeymoore recommended increasing benefits for the very old, increasing benefits for widowed spouses, increasing benefits for very low income workers, providing “across the board” benefit increases for all beneficiaries, and adopting a better cost-of-living adjustment (COLA) measure.

She suggested increasing benefits by a uniform dollar amount or by 5% for beneficiaries age 85 and older, and increasing benefits for surviving spouses to 75% of the sum of worker benefits received by the couple with a cap not to exceed the average earnings of one person or not to exceed the maximum earnings of one person that taxed and counted for Social Security. To address very low income workers, she suggested updating a special minimum benefit to 125% of the current poverty threshold and increasing benefits for single retirees at retirement and/or upon reaching the age of 85. She also suggested benefits be increased to meet the projected income needs of future retirees who have been harmed by macroeconomic factors beyond their control, such as stagnating wages and the recession. Finally, Rockeymoore suggested the Social Security system start using the consumer price index-elderly (CPI-E) as a more accurate means of determining annual COLAs, since it will factor in added costs such as those for health care.

Considering that individuals are living longer and many are working longer to make up for inadequate retirement savings, Jason J. Fichtner, senior research fellow at the Mercatus Center at George Mason University in Arlington, Virginia, suggested removing obstacles that discourage older Americans from remaining in the work force longer, such as increasing the special minimum benefit given to older Americans, raising the eligibility age, increasing the delayed retirement credit, and adjusting the benefit formula. He also suggested improving the financial literacy of workers.

Fichtner suggested raising the age workers are first eligible for benefits to 65, rather than 62. This would necessarily delay many claims and correlate with continued employment. Similarly, he suggested that increasing Social Security’s delayed retirement credit could result in “another positive work incentive.”

Fichtner also suggested a redesign to the benefits formula that would operate on each separate year of work rather than on one’s career average earnings. He pointed out that the current formula causes one’s returns from Social Security to drop with extended work, as one’s career average earnings rise and the system’s progressive benefit formula thus delivers lower returns.

On the subject of financial literacy, Fichtner testified, “Although people are living longer, a significant fraction of workers continues to start receiving Social Security benefits early, though this permanently reduces monthly benefits. Research links financial literacy and saving behavior, indicating that the less financially literate are also less likely to plan for retirement. Better informing people about the full costs of claiming benefits early may lead to more people choosing to delay claiming until the full retirement age, or longer, thus improving labor-force participation among seniors.”

Stephen Goss, chief actuary for the Social Security Administration in Baltimore, Maryland, said, Social Security reform is urgently needed, especially with retirees “increasingly at risk for having no other income than Social Security benefits.”

Goss noted that while certain career earners may have Social Security benefits as high as 70% of career average earnings, such individuals “tend to be far more dependent on Social Security as a sole source of retirement income,” adding that “about one-third of Social Security beneficiaries have little if any income outside of that provided by Social Security.”

According to Goss, any solutions to issues with the future of Social Security, and all sources of retirement income, need to address the aging of the population and the adequacy of monthly Social Security benefits in light of this aging.

More information about the hearing, including copies of the testimonies, is available here.

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