Incentive Fees and Mutual Funds

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Abstract
The impact of incentive fees on management performance has become an increasingly important subject in the literature of financial economics. Yet, despite a large number of theoretical articles on the impact of incentive fees, there has been almost no empirical testing of the theories. In this article we use a carefully constructed sample of mutual funds to study the impact of incentive fees. Mutual funds are a particularly interesting vehicle for studying incentive fees, for funds exist that have incentive fees and funds exist that do not have incentive fees. In addition, the data provided by mutual funds are sufficiently detailed to allow correction for survivorship bias. We find that while many of the theoretical implications of the literature on incentive fees are borne out, some are not. We find that funds with incentive fees have not, on average, been able to earn positive incentive fees. This suggests that managers on average haven't been able to outperform their benchmarks or to design benchmarks which work to their advantage. However, funds with incentive fees have an average risk-adjusted performance of about zero, which is higher than most studies have found for funds without incentive fees. This suggests that funds with incentive fees have at least some tendency to attract superior managers and/or to obtain more effort from managers in place. While there seems to be a modest impact of incentive fees on average returns, there clearly is a larger impact on risk taking. Funds with incentive fees have higher risk than funds without incentive fees. Whether risk taking is measured in terms of tracking error or total risk, incentive fees cause risk taking. In addition, as theories suggest, funds that underperform their benchmarks in the first part of an evaluation period increase risk in the second part, while funds that are overperforming relative to the index tend to reduce risk. Managers using incentive fees often pursue non-benchmark strategies in an attempt to earn excess returns and higher fees. For example, many funds with the S&P 500 as their benchmark have significant exposure to small stocks. Surprisingly, funds on average have a beta less than one when a beta greater than one would have provided a higher expected return with potentially the same tracking error. There are two types of managers subject to incentive fees: internal managers and external managers. Internal managers play a larger role in setting the incentive benchmarks, while outside managers are more at risk of being replaced. Inside managers do better relative to the benchmark than outside managers, and they also take greater risk in terms of total risk and deviations from the benchmark. Finally, we find that funds that have incentive fees attract more capital ceteris paribus than funds in general. This is an added reason why managers might choose to use an incentive fee.

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