A substantial part of investment management is delegated to institutions such as mutual funds, pension funds, university endowments, and hedge funds. Mutual funds account for a significant part of this market. Prior applied investment research has mostly ignored the important distinction between the fund family and the fund managers it employs to manage its different funds; a leading example is Berk and Green (2004).
A better understanding of the interaction between fund families and their employees who manage the assets can help improve outcomes both for institutions that manage investments and their investors.
In a recent paper, we take a close look at the role of fund managers within the fund families they work for to reach a better understanding of the economic relationship between the two (Ibert et al. 2017).
We have three main results, each of which is interesting in its own right, and each of which challenges common perceptions. We find:
- considerably lower sensitivity of pay to manager-level assets under management, compared to the fixed fraction of assets under management typically charged by funds;
- surprisingly weak sensitivity of pay to performance, even after accounting for potential non-linearity in pay to performance sensitivity and longer histories of performance; and
- firm-level characteristics, which typically are ignored in the literature, add substantial explanatory power for manager compensation.
A unique dataset of manager compensation
In the paper, we construct a unique dataset containing information on the income of Swedish fund managers over the period January 1994 to December 2015. We first extract the manager names from Morningstar Direct, then match managers to their social security numbers using publicly available sources, and finally match these social security numbers to the Swedish tax records, which contain the manager income data.
The Swedish setting constitutes a good laboratory to investigate the mutual fund industry. Sweden has one of the deepest and most competitive mutual fund sectors in the world. The size of the total mutual fund industry’s assets under management (AUM) relative to GDP is one of the highest in the world (8th in Khorana et al. 2005). By 2015, Sweden had almost caught up with the US in terms of AUM/GDP (77% versus 88%). Sweden also is representative in terms of fund return performances and fees charged in the cross-section of developed countries between 2001 and 2007 (Ferreira et al. 2012). In a more recent sample, Sweden has comparable fees to the US, which are the lowest in the world. Finally, the pay culture for skilled labour in Sweden may not be all that different from that in the US. The elasticity of CEO pay to firm assets is similar in the two countries (0.27 versus 0.3) (Adams et al. 2016).
In the mutual fund industry, the predominant contract between investors and funds is one where fees are proportional to asset under management. A key question is what is the managers’ cut and how does it vary as revenues vary. Our data allow us a unique vantage point in helping to answer this question.
The top panel of Figure 1 plots log manager pay as a function of log manager revenue, a natural measure of size.1 It shows a strong linear relationship between the two.
Figure 1 Elasticity of pay to revenue and performance
However, closer inspection reveals that the slope is considerably lower than one, implying a concave relationship in levels between the two. Using a regression analysis, we find an elasticity of compensation to revenues of 0.15. A 1% increase in revenues generated by this manager increases her compensation by 0.15%, lowering the manager’s share of revenue by 85%. A one standard deviation increase in revenues increases pay by 0.4 standard deviations, implying there is far from complete pass through of fund revenues to managerial compensation. Doubling of revenue from $6.2 million (average) to $12.4 million (AUM from $450 to $900 million) increases pay from $210,000 to $241,200. This leads to a drop in the share of revenue going to managers’ pay from 3.3% to 1.9%. Owners, on the other hand, capture the bulk of revenue increases (99.5% in this example).
Theory suggests that a component of a fund manager’s pay should be directly tied to return performance, especially when there is uncertainty regarding managers’ ability. We find a surprisingly weak sensitivity of pay to performance.
The bottom panel of Figure 1 shows the relationship between log labour income and log abnormal returns, where abnormal returns are defined as the gross (before fees) return in excess of the benchmark as stated in the fund’s prospectus. As apparent from the figure, the relationship is much weaker than the one between labour income and revenues.
A regression analysis shows that a one percentage point increase in abnormal return – not an inconsequential increase – raises pay by only 0.39%. A one standard deviation increase in abnormal return performance increases compensation by 0.04 standard-deviations; ten times less than a one standard deviation increase in revenue! The weak relationship persists even after accounting for potential non-linearity in pay to performance sensitivity and longer histories of performance. It is mostly driven by talented managers on average generating higher returns and earning higher labour income, rather than time series variation for a given manager.
Pay performance sensitivity increases once the components of revenue that are correlated with current and past abnormal returns, such as fund flows, are accounted for. However, even then, it remains economically small, and the component of revenue that is unrelated to past fund performance remains the dominant driver of pay. This suggests that an important component of managers’ compensation may be for non-performance related revenue-generating skills, such as asset gathering, sales and marketing, people management, and so on.
The role of the fund family
In the analysis discussed above, we found an economically modest effect of manager-level revenue on pay. We further found a very low sensitivity of pay to manager-level performance. This leaves ample room for other determinants of pay. Mutual fund companies manage multiple funds, raising the possibility that manager pay depends not only on the revenue and performance of the funds she is responsible for, but also on the revenue and performance generated by other funds in the same fund family (i.e. firm).
We show that firm-level characteristics, which are typically ignored in the literature, add substantial explanatory power for manager compensation. The explanatory power of the regression (i.e. the R-squared) increases from 23% to more than 50% once we account for the common component of pay to managers within the same fund family in a given year. Furthermore, the elasticity of pay to firm revenue, excluding revenue managed by the given manager, is about half as large as that to manager revenue. Since one standard deviation in log firm-level revenue is 50% larger than one standard deviation in log manager revenue (2.4 vs. 1.8), the sensitivity of manager compensation to firm revenue is comparable to that of manager revenue.
To further investigate the impact of the three components (manager revenue, performance, and firm revenue) on manager pay, we conduct a joint vector auto regression analysis and investigate the dynamic response of manager pay to independent one standard deviation shocks to each of the three. Figure 2 plots the response, over time, of log pay to orthogonal one standard deviation shocks to each of the three components. The impact of firm-level revenue is two-thirds that of manager-level revenue, and at least as persistent. The impact of performance is the smallest and least persistent.
Figure 2 Dynamic response of managerial pay to performance, manager revenue, and firm revenue shocks
In further analysis, we show that firm profit also matters considerably. Firms with higher profits pay significantly more. At the same time, profitability lowers the sensitivity of compensation to manager revenues and increases that to performance.
The evidence we uncovered is consistent with a compensation package that contains one component that depends on manager-level revenues and another component that comes out of a firm-wide bonus pool. This bonus pool only exists when the firm makes a profit. Pay-for-performance is only present in profitable firms, but even there plays a small role in determining compensation.
Compensation of mutual fund managers is paramount to understanding agency frictions in asset delegation, yet the prior literature has mostly been silent on this, bundling managers with the funds they run. At least in part, this has been due to lack of data on fund managers’ contracts and their compensation.
In Ibert et al. (2017), we collect a novel dataset on Swedish fund managers’ income. This provides us with a unique opportunity to start peeking into this ‘black box’, and to better understand the role of fund managers within the firms they work for.
Our evidence highlights the limitations of considering managers in isolation from the fund family they work for. Managers are an integral part of a fund family and their incentives are shaped not only by how well they manage their own fund, but also by how they integrate within the rest of the family, their relative bargaining power – which depends on their added value – and the corporate culture. Consequently, intra-fund family incentive frictions will impact managers’ portfolio allocation decisions.
The small magnitude of pay-to-performance sensitivity and the modest elasticity of pay to revenue, combined with the important role firm-level variables play, are instructive for research and practice going forward, as models of delegation and our understanding of the related frictions improve.
Adams, R B, M Keloharju, and S Knupfer (2016), “Are CEOs born leaders? Lessons from traits of a million individuals”, SSRN, Working Paper No 2436765.
Berk J, and R C Green (2004), “Mutual fund flows and performance in rational markets”, Journal of Political Economy 112: 1269–1295.
Ferreira, M A, A Keswani, A F Miguel, and S B Ramos (2012), “The flow-performance relationship around the world”, Journal of Banking and Finance: 1759-1780.
Ibert, M, R Kaniel, S Van Nieuwerburgh, and R Vestman (2017), “Are mutual fund managers paid for investment skill?”, Review of Financial Studies, forthcoming.
Khorana, A, H Servaes, and P Tufano (2005), “Explaining the size of the mutual fund industry around the world”, Journal of Financial Economics 78: 145–185.
 Results are similar if instead of revenues we use AUM.