Performance-Based Fees, Incentives and Dynamic Tracking Error Choice

Bernd Scherer

Mutual funds and corporate pension funds are increasingly using incentive fees, or performance-based fees (PBFs), to reward their fund managers. Janus Capital Group Inc established performance incentives for the managers of 13 of its 59 funds in September 2005. Vanguard and Fidelity are just another two examples of investment companies that use incentive fees. Even in the absence of explicit performance-based fees, Brown et al (1996) and Chevalier and Ellison (1997) have shown that an implicit performance-based compensation structure arises from proportional fees as a result of the fact that net investment flows into funds respond strongly to recent performance.

The effects of performance-based fees on investment decisions have been documented in a number of papers. Grinblatt and Titman (1989) apply option pricing theory to analyse the manager’s risk incentives in a single-stage framework. They find that improperly designed PBF contracts create incentives for gaming by varying the risk of the fund. Carpenter (2000) examines the optimal dynamic investment policy for a risk-averse fund manager and finds that the convexity of the option-like compensation structure can lead the

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