Why Constrain Your Mutual Fund Manager?

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Abstract
We examine the form, adoption rates, and economic rationale for the investment restrictions found in the contracts between mutual fund investors and managers. Based on a sample of U.S. domestic equity funds from 1994 to 2000, we find systematic patterns in the use of policy constraints that are consistent with an optimal contracting view of the fund industry. In particular, restrictions are more frequently present when it is relatively less beneficial to use direct methods to monitor manager behavior, including when (i) boards contain a higher proportion of inside directors, (ii) the portfolio manager is more experienced, (iii) the fund is managed by a team rather than an individual, and (iv) the fund does not belong to a large organizational complex. We find no evidence that low- and high-constraint funds produce different risk-adjusted returns, which is also consistent with the existence of a contracting equilibrium.

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