Remuneration of Fund Managers: Pay disclosure hinges on profitability, contribution to team

What does the regulator hope to achieve — is the most common lament. Why not restrict it to just the CIO and relevant fund manager, why all employees earning above the threshold — is another question.

How will it help the investor ?

All the industry players we spoke to were unanimous that the remuneration profile must be linked with fund performance. Some included other factors too like the overall profitability of the business, contribution to the overall investment team result, and business development contribution. But fund performance stood tall because the general consensus is that if compensation is largely driven by fund performance, it aligns the fund manager’s interests with the interests of the investors. On the face of it, that sounds perfect. But one has to dig deeper.

[related-post]

Is the fund manager rewarded?

If yes, is it for exceeding a relevant benchmark and which one is it? If it is compared to a benchmark and peer group norm, what weights are accorded to each? Are trailing or rolling returns taken into account?

Is the fund manager’s remuneration tied to short-term returns or a sufficiently long time horizon? What time periods are considered and what weights are accorded to those periods?

If fund manager’s compensation is tied to performance over short time periods, would it not be tempting to take on excessive risks in order to maximise his bonus? It could also trigger risk-taking tactics to play catch-up at the year-end. Is the fund manager’s compensation tied to asset growth, even partly? This is not a good sign because fund assets, as a metric, are a better gauge of marketing craft than investing acumen.

In 2004, Morningstar unveiled the Stewardship grade for mutual funds in Chicago. The analysts went to great extents to determine the structure or specific formula behind a manager’s compensation — which was a difficult task given that manager compensation in the US at that time was kept under wraps and not disclosed to the public. The information obtained by analysts helped them answer important questions regarding Stewardship, mentioned below:

1) Does the pay structure complement the management’s strategy?

Selected American: The compensation scheme paid out bonus awards in fund shares, with those grants vesting only if the fund outperformed the S&P 500 Index and the fund’s peers over the ensuing five years. This complemented the fund manager’s low-turnover, value-investing ethos.

Oak family of funds: Managers were paid a nominal base salary and received bonuses on a quarterly basis based on two factors — the revenue Oak brings in over the period and founder’s assessment of each manager’s performance. This quarterly payout approach seemed at odds with the low-turnover, long-term-oriented strategy.

Longleaf Partners: One component of the bonus compensation methodology measured the performance of individual stock picks in terms of how much the intrinsic value of the firm’s business increased over the course of the year. This encouraged managers to pick companies that created value for shareholders.

2) Does the compensation structure emphasise long-term, rather than short-term investment objectives?

Putnam: The compensation system ensured that managers kept their eyes on the ball over the long haul. At some funds, performance incentives generally accounted for 70 per cent of compensation. The majority of the incentive goals were based on fund returns relative to peer groups over 3 and 5-year periods. Specific goals were to rank in the top three of those peer groups and avoid falling into the worst quartile, which encouraged managers to shoot for outperformance.

TIAA-CREF: Incentive structure at some funds entailed that the bonus calculation skewed heavily to the trailing 1-year period.

3) Does the compensation structure mitigate or heighten potential conflicts of interest?

Ariel Fund: The bonus system was tied to firm profitability, which is often a thorny setup given that it’s difficult for managers to effectively serve the management company and the fund shareholder. However, the fund’s board set up clear portfolio-management goals designed to ensure that the fund is managed consistently and that the manager is not taking on risks that are intended to drive the firm’s profitability. The board evaluated whether each fund’s forward P/E ratio remained at a significant discount to appropriate benchmarks and whether turnover was kept at a reasonable level.

The above illustrations may no longer be accurate as of today. However, it indicates that disclosure of the structure of pay does help investors make sensible decisions. It proves that while transparency can be a burden, it is also a tremendous asset.

Worth noting is at that time (regarding the above examples), the Securities and Exchange Commission did not require mutual funds in the US to disclose how their portfolio managers are compensated. The ruling on disclosing the structure of compensation was made mandatory only in 2005.

The issue continues to be debated. Recently, Investment Week reported that Richard Woolnough, who manages the Optimal Income, Corporate Bond and Strategic Corporate Bond funds for Prudential, received bonuses of £17.5 million and £15-odd million in 2013 and 2014. The Independent speculated a fall in his 2015 bonus citing bad performance. In Australia the remuneration of fund managers is closely guarded, despite some noise a few years ago.

For better or for worse, India is one step ahead in that area.

News playlist: