Compensation for fund manager: A multi factor model

Abstract

As more and more people are putting their money into the care of professionals, it's time to ask if the people investing your money are properly motivated - that is, if they are given incentives to make the right decisions when they construct portfolios of risk y securities. Active portfolio managers attempt to beat the market by identifying over- and under-valued stocks. They invest in the securities they deem to be undervalued and in some cases short-sell the ones that they believe are overvalued. By contrast, passive fund managers adopt a buy-andhold strategy in which their goal is to mimic the performance of a market index such as the SIMP CNX Nifty. Passive managers buy stocks in their market proportions - if the market value of Infosys is exactly the twice that of iflex Solutions Ltd, then a passive manager has exactly twice as much invested in Infosys as in iflex Solutions Ltd. Experts have long noted that the average performance of all the active funds cannot exceed the performance of a passive fund that buys the market index. This is because, on average, the active managers must hold the market index. If one active manager is bullish on Infosys and wants to buy more Infosys for his portfolio, he must buy it from someone else who is bearish on Infosys and wants to reduce his holdings. In other words, a manager can deviate from holding securities in his market proportions only if someone else deviates in the opposite way. Across all of the active funds, these deviations cancel out and so the average performance of active funds cannot be greater than the performance of the market. Active managers are engaged in a zerosum game with the gains of the winners exactly offset by the losses of the losers. In fact, since active managers incur trading costs, the game is actually a negative sum game. On average, active managers do under-perform the market and often by a wide margin. But this does not rule out the possibility that some active managers are able to beat the market with some consistency. Active managers take a view on the market based on the information available to them. Investors pay an active management fee for this information. They look at how these managers should be compensated with incentives to use their information in a way that benefits those who have entrusted money to them. An active portfolio manager's compensation package can be assembled from three components: 1) A fixed fee that is paid regardless of how well or poorly the portfolio performs 2) A fee that is based on the over-all return earned on the portfolio 3) A fee that is based on how well the portfolio does relative to the return earned on a benchmark index. In the past, most active managers are rewarded using schemes based only on the first two components. Recently, greater emphasis has been placed on the use of benchmarks.