Do Mutual Fund Managers Who Use Incentive Compensation Outperform Those Who Don't?

Incentive compensation appears to motivate investment managers to provide superior returns for their investors. Several competing theories of incentive pay contracts are considered. The principal/agent theory holds that a principal basing an agent's pay, at least in part, on output creates an incentive for even an unmonitored agent to increase output. A variation of this theory suggests that incentive pay contracts are more likely to be used with agents with little or no performance history. The signaling/screening theory states that contracts are used by both employer and employee to indicate what characteristics are important for a given job. The research of Grinold and Rudd (1987) suggests that large funds or families of funds tend to use such incentives and that, within a family of mutual funds, incentive-fee funds should outperform fixed-fee funds. Results of database analysis show that incentives may act to both encourage fund managers and screen risk and that larger funds are more likely to use them.