Contractual and Tournament Incentives in the Mutual Fund Industry

Abstract

I study the impact of contractual incentives on the behaviour of mutual fund managers in annual tournaments. I show that linear contracts as opposed to concave ones induce managers to make larger risk adjustments in response to their relative performance ranks. I argue that contracts with linear fee structure directly translate the convex relationship between past fund returns and fund size into a convex relationship between past performance and managerial pay, whereas concave contracts distort this relationship and make it less convex. I also demonstrate that higher fee rates encourage fund managers to engage into annual tournaments, as they strengthen the connection between fund size and managerial pay in comparison with lower fee rates. The above results are robust to controlling for funds characteristics, such as fund size, age and turnover, as well as year and style-fixed effects.

Keywords: Compensation, risk-taking, fees, convex contract, linear contract

JEL Classification: G11, G23, M52