Gaming Performance Fees By Portfolio Managers

We show that it is very difficult to devise performance-based compensation contracts that reward portfolio managers who generate excess returns while screening out managers who cannot generate such returns. Theoretical bounds are derived on the amount of fee manipulation that is possible under various performance contracts.We show that recent proposals to reform compensation practices, such as postponing bonuses and instituting clawback provisions, will not eliminate opportunities to game the system unless accompanied by transparency in managers' positions and strategies. Indeed, there exists no compensation mechanism that separates skilled from unskilled managers solely on the basis of their returns histories.

[1]  William N. Goetzmann,et al.  Behavioral Factors in Mutual Fund Flows , 1999 .

[2]  J. E. Lloyd,et al.  Aggressive Mimicry in Photuris Fireflies: Signal Repertoires by Femmes Fatales , 1975, Science.

[3]  Dean Phillips Foster,et al.  A Martingale Test for Alpha , 2008 .

[4]  David Gale,et al.  A Curious Nim-Type Game , 1974 .

[5]  Richard W. McEnally,et al.  The Performance of Hedge Funds: Risk, Return, and Incentives , 1999 .

[6]  Helder P. Palaro,et al.  Who Needs Hedge Funds? A Copula-Based Approach to Hedge Fund Return Replication , 2005 .

[7]  Alvaro Sandroni,et al.  Calibration with Many Checking Rules , 2003, Math. Oper. Res..

[8]  J. Carpenter,et al.  Does Option Compensation Increase Managerial Risk Appetite? , 1999 .

[9]  William N. Goetzmann,et al.  Portfolio Performance Manipulation and Manipulation-Proof Performance Measures , 2004 .

[10]  J. Hull.  Options, Futures, and Other Derivatives , 1989 .

[11]  Glenn Ellison,et al.  Risk Taking by Mutual Funds as a Response to Incentives , 1995, Journal of Political Economy.

[12]  Peter Tufano,et al.  Costly Search and Mutual Fund Flows , 1998 .

[13]  P. Sinclair.  Deficits, Debts and Defaults - Past, Present and Future , 2011 .

[14]  Alvaro Sandroni,et al.  Manipulability of Future-Independent Tests , 2008 .

[15]  Martin J. Gruber,et al.  Another Puzzle: The Growth in Actively Managed Mutual Funds , 1996 .

[16]  David M. Kreps,et al.  Martingales and arbitrage in multiperiod securities markets , 1979 .

[17]  Jasmina Hasanhodzic,et al.  Can Hedge-Fund Returns Be Replicated?: The Linear Case , 2006 .

[18]  Laura T. Starks,et al.  Performance Incentive Fees: An Agency Theoretic Approach , 1987, Journal of Financial and Quantitative Analysis.

[19]  L. Bebchuk,et al.  Regulating Bankers' Pay , 2009 .

[20]  Jens Carsten Jackwerth,et al.  Incentive Contracts and Hedge Fund Management , 2007 .

[21]  Alvaro Sandroni,et al.  The reproducible properties of correct forecasts , 2003, Int. J. Game Theory.

[22]  Ran Spiegler,et al.  The market for quacks , 2006 .

[23]  A. Siegel,et al.  The Efficient Use of Conditioning Information in Portfolios , 2001 .

[24]  Andrew W. Lo,et al.  Risk Management for Hedge Funds: Introduction and Overview , 2001 .

[25]  R. Vohra,et al.  Calibration: Respice, Adspice, Prospice , 2011 .

[26]  Paolo Guasoni,et al.  Performance Maximization of Actively Managed Funds , 2010 .

[27]  E. Lehrer.  Any Inspection is Manipulable , 2001 .

[28]  Lucian Arye Bebchuk,et al.  Perspectives on Corporate Governance: Pay Without Performance: Overview of the Issues , 2006 .