Incentive fees tie managerial compensation to performance and are used in 1.7 percent of stock and bond mutual funds, controlling 10.5 percent of mutual fund assets. Theoretically, the use of incentive fees should align managers' incentives and attract better managers. The use of incentive fees may also signal higher performance to investors, thus allowing the fund to attract more assets. The authors examine the performance of 108 funds during 1999 and report the following findings.
Incentive fees tie managerial compensation to performance and are used in 1.7 percent of
stock and bond mutual funds, controlling 10.5 percent of mutual fund assets.
Theoretically, the use of incentive fees should align managers' incentives and attract
better managers. The use of incentive fees may also signal higher performance to
investors, thus allowing the fund to attract more assets. The authors examine the
performance of 108 funds during 1999 and report the following findings.
Mutual fund managers with incentive fees exhibit better stock-selection ability, and
their funds have lower expense ratios. Curiously, funds with incentive fees do not, on
average, earn positive or negative incentive fees: A beta of less than 1 causes a fund
to underperform its benchmark. Managers with incentive fees are more likely to increase
risk after periods of low performance and decrease risk after periods of high
performance. These managers are more likely to bet on securities not included in the
benchmark. Overall, investors like the idea of incentive fees, as evidenced by a higher
growth rate of fund inflows into incentive-fee funds than non-incentive-fee funds.