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.

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.

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.