Performance Incentive Fees: An Agency Theoretic Approach

This paper employs recent developments in agency theory to study the impact that com? pensation contracts have on portfolio management investment decisions in a restricted mean-variance world. Two types of incentive contracts for mutual fund managers are ana? lyzed and compared. The results show that the "symmetric" contract, while not necessar? ily eliminating agency costs, dominates the "bonus*' contract in aligning the manager's interests with those ofthe investor. Investment companies and, by extension, their managers, control a large and increasing percentage ofthe aggregate wealth of their clients. More investors are putting their money under the control of these advisers than ever before. Con? sequently, potential conflicts of interest arise between investment company own? ers and their financial management advisers. The Securities and Exchange Com? mission (SEC) has been concerned with this issue for a number of years. The agency has commissioned several studies to investigate the issue and has set forth certain rulings concerning the behavior of investment company advisers. Of par? ticular importance has been the compensation arrangement between mutual fund management and the fund owners. In fact, the SEC has issued specific guidelines regarding allowable fee schedules for managers. These guidelines have Ied to a policy debate concerning whether the SEC has been too stringent or not stringent enough in regulating compensation for investment managers. The present study takes a new approach to this problem in an attempt to resolve this debate. The fiduciary relationship between mutual fund management and the inves? tors they represent may be viewed as a principal-agent relationship. Conse? quently, the methodology from the agency literature can be applied to study the impact of various compensation arrangements on the potential conflict of interest between these two groups.