Newswise — University of Iowa finance professor Ashish Tiwari knows that "bonus" is sort of a bad word in business these days.
Economists and financial analysts pin much of the blame for the current economic problems on the monumental bonuses paid to corporate CEOs, especially of Wall Street investment firms.
Critics say the bonuses encouraged executives to take wild risks with other peoples' money that proved so irrational they eventually dragged their companies down.
So it might not be the best time to suggest that federal regulations restricting mutual fund managers from collecting performance-based bonuses be relaxed. But Tiwari, who is a faculty member in the Tippie College of Business, still thinks it might be a good idea because his research suggests portfolio performance would improve if such bonuses were allowed.
The Securities and Exchange Commission placed restrictions on performance-linked bonuses starting in 1971 to protect investors from money managers taking excessive risks with a client's money in search of better performance and a higher bonus. While bonuses are still allowed, SEC regulations require managers to also be penalized if their fund underperforms. Since most managers presumably don't want to pay the penalty, they instead opt to collect an annual management fee that is based on the value of the portfolio.
In his forthcoming paper, "Incentive Contracts in Delegated Portfolio Management," co-authored with Louisiana State University finance professor and Tippie College alumnnus Wei Li, Tiwari suggests that allowing bonuses without the underperformance penalty could provide incentives significantly increasing the quality of a manager's information.
While working harder to find better information doesn't always translate to improved portfolio performance in a given period, Tiwari said it's an important step in the right direction.
Success, though, hinges on one important caveat, Tiwari said -- a benchmark must be used to determine the bonus. Even more important, he said, is that the benchmark needs to be aligned with the manager's investment style. Such a benchmark, he said, can help determine if the manager is truly producing superior results, or simply riding a wave.
"Without an appropriate benchmark, you don't know if a great return was the result of the manager's ability, or if the overall market performance was so good that it's a case of a rising tide lifting all boats," Tiwari said.
Also important, he said, is that the benchmark used to evaluate the manager's performance accurately reflects the manager's investing style. Tiwari said that it doesn't make sense to hire a fund manager who favors small-cap stocks and then evaluate her performance using, say, the large-cap heavy S&P 500 index as a benchmark.
"If the benchmark has no semblance to the manager's strategy or style, they are likely to ramp up risk without investing in information acquisition," he said.
If that happens, Tiwari said the manager might effectively adopt a "who cares" management style and start investing in things she isn't fully knowledgeable about, increasing the investor's risk.
As for the current popular criticism of bonuses, Tiwari said bonuses paid to mutual fund and portfolio managers are fundamentally different from most of those paid to corporate executives. The latter are often based on the absolute performance of the firm or its stock price, which means some executives might take undue risk to drive up the short-term profits and stock price at the expense of sound corporate management.
Mutual fund managers, on the other hand, would receive a bonus only if the fund beat its benchmark, so the manager would have an incentive to take only the right level of risk needed to hit that target. In this sense, Tiwari said the appropriate choice of benchmark is crucial as it affects both the effort and the risk-taking incentives of the manager.
Tiwari notes that there are some unregulated investment vehicles that do pay performance-linked bonuses, such as hedge funds. Many of those funds took huge risks with their investors' money and turned out to be some of the leading dominoes in the recent financial crisis.
But he said mutual funds are different from hedge funds because they come with other checks and balances to make sure the money is being soundly invested, such as independent governing boards, investment restrictions, and volumes of other federal laws and SEC regulations.
Tiwari's and Li's paper will be published in a forthcoming issue of the Review of Financial Studies.
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