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Fee Speech: Adverse Selection and the Regulation of Mutual Funds

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  • Sanjiv Ranjan Das
  • Rangarajan K. Sundaram

Abstract

The Investment Advisors Act of 1940 (as amended in 1970) prohibits mutual funds in the US from offering their advisers asymmetric incentive fee' contracts in which the advisers are rewarded for superior performance via-a-vis a chosen index but are not correspondingly penalized for underperforming it. The rationale offered in defense of the regulation by both the SEC and Congress is that incentive fee structures of this sort encourage excessive' risk-taking by advisers. This paper uses an adverse selection model with multiple funds and multiple risky securities to study this issue. We find that incentive funds do, as alleged, lead to more (and suboptimal) risk-taking than do symmetric fulcrum fees.' Nevertheless, from the more important welfare angle, we find that investors may be strictly better off under asymmetric incentive fee structures. Thus, there appears to be little justification for this legislation.

Suggested Citation

  • Sanjiv Ranjan Das & Rangarajan K. Sundaram, 1998. "Fee Speech: Adverse Selection and the Regulation of Mutual Funds," NBER Working Papers 6644, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:6644
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    References listed on IDEAS

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    1. Admati, Anat R & Pfleiderer, Paul, 1997. "Does It All Add Up? Benchmarks and the Compensation of Active Portfolio Managers," The Journal of Business, University of Chicago Press, vol. 70(3), pages 323-350, July.
    2. William N. Goetzmann & Jonathan Ingersoll, Jr. & Stephen A. Ross, 1998. "High Water Marks," NBER Working Papers 6413, National Bureau of Economic Research, Inc.
    3. Anthony W. Lynch & David K. Musto, 1997. "Understanding Fee Structures in the Asset Management Business," New York University, Leonard N. Stern School Finance Department Working Paper Seires 98-050, New York University, Leonard N. Stern School of Business-.
    4. Heinkel, Robert & Stoughton, Neal M, 1994. "The Dynamics of Portfolio Management Contracts," The Review of Financial Studies, Society for Financial Studies, vol. 7(2), pages 351-387.
    5. Golec, Joseph H., 1992. "Empirical Tests of a Principal-Agent Model of the Investor-Investment Advisor Relationship," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 27(1), pages 81-95, March.
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    Cited by:

    1. Bank for International Settlements, 2003. "Incentive structures in institutional asset management and their implications for financial markets," CGFS Papers, Bank for International Settlements, number 21.
    2. Goriaev, A.P. & Palomino, F.A. & Prat, A., 2000. "Mutual Fund Tournament : Risk Taking Incentives Induced by Ranking Objectives," Other publications TiSEM 41aeada1-3d53-4828-bfae-2, Tilburg University, School of Economics and Management.
    3. Ana C. Díaz†Mendoza & Germán López†Espinosa & Miguel A. Martínez, 2014. "The Efficiency of Performance†Based Fee Funds," European Financial Management, European Financial Management Association, vol. 20(4), pages 825-855, September.
    4. Igan, Deniz & Pinheiro, Marcelo, 2012. "The effects of relative performance objectives on financial markets," MPRA Paper 43452, University Library of Munich, Germany.
    5. Palomino, F.A. & Prat, A., 1998. "Dynamic incentives in the money management tournament," Discussion Paper 1998-107, Tilburg University, Center for Economic Research.

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