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.