(Reuters) - (James Saft is a Reuters columnist. The opinions expressed are his own)
If you want to understand an industry you have to understand how employees get paid, and for what.
In the mutual fund industry the one thing fund managers are not paid for, as a general rule, is performance.
A new study using the publicly available tax returns of mutual fund managers in Sweden portrays a mutual fund industry in which the interests of fund company owners and their managers are aligned, but those of fund managers and investors only kind of bump along together, almost randomly.
Given that investment management is at the heart of how society allocates capital, this is a problem.
“We find a weak relationship between pay and performance, but a strong relationship between pay and size, measured as fee revenue,” Markus Ibert of the Stockholm School of Economics, Ron Kaniel of Rochester University, Stijn Van Nieuwerburgh of New York University and Roine Vestman of Stockholm University write. (here)
Using public tax return data (in Sweden all tax returns are public), the study identified 529 Swedish mutual fund managers and then compared their earnings to the size, revenue and relative performance of the funds they steer.
The study found a “strong” relationship between pay and the size of funds under a manager’s control, with a one standard deviation increase in revenue driving a 25 percent increase in pay.
That makes sense, given that most mutual funds charge a flat fee on assets under management, and shows that the fund firm and the manager benefit together from growth.
That said, fund firms capture the lion’s share of increases in revenue.
As for performance, a one-standard-deviation increase in abnormal return in a manager’s fund only drives a 2.5 percent increase in pay. On other measures, the pay-for-performance effect is “no longer different from zero,” according to the study.
So the reward for increasing funds under management is 10 times greater, on a like-for-like basis, than that for increasing returns for investors.
But wait, I can almost hear you say, surely funds under management rise with good performance, and thus drive compensation? Well, not in this sample. The study found no evidence that positive performance by a manager in a given year drove an upswing in funds under management in that year or the year after.
Fund managers get rewarded, according to the study, for inflows unrelated to superior performance, for running additional funds (which may dilute performance, other studies have found) or for taking over management of different funds with higher fees.
BEST PAID BEST, NOT BY MUCH
There is, the study showed, stronger evidence of pay for performance over longer periods, but that may be driven by sample issues and the size of increasing pay “remains modest.”
The best-performing fund managers are paid better than the worst. Managers in the top quartile make 9 percent more than managers in the bottom fourth. That’s meaningful, but hardly the kind of bump you would expect if the best interests of savers were properly aligned with the people who manage their money.
The study neither suggests remedies to this situation, nor underlying causes. The results, however, may not prove but do rhyme nicely with the idea that many fund managers aren’t putting their best efforts into buying the securities which will go up most but into managing their own career risk.
The well-known phenomenon of closet tracking may well be related to the pay figures. Managers, many of them, tend to only take small bets against the index, a strategy which minimizes their risk of seriously lagging the markets and finding themselves out of a job. It also, of course, not only means that consumers are paying for active management while getting an expensive index-like fund, but that strong outperformance is less likely.
As for the relationship between inflows and pay, it strikes me as possible that this is largely driven by events outside a manager’s control. Retail investors chase returns, but usually in absolute rather than risk-adjusted terms. That means they plunge into what was hot last year, rather than allocating to an asset class and seeking out managers who create abnormally large returns relative to risk.
And again, managers will have a natural tendency to buy what is going up within their index, guarding against lagging badly enough to be vulnerable to getting fired.
It is a heck of a way to organize an important industry; it is hard to blame investors who throw up their hands and just stick their money into index funds.
Editing by James Dalgleish
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