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Mutual Fund News

Getting incentives (and behaviour) right

Dan Richards is president of Strategic Imperatives. He is a faculty member in the MBA program at the Rotman School at the University of Toronto.

When it comes to motivating people, there are three simple words to remember: "Compensation drives behaviour."

That's true of high-powered investment bankers and traders pulling down million-dollar bonuses - and it's also true for the fund companies and portfolio managers Canadians entrust with billions of dollars in savings.

Compensation can be a powerful tool for both good and ill. Well structured, it can create incentives for the right kind of behaviour, while poorly structured compensation can be incredibly destructive. There are two keys to structuring compensation - fostering the right kind of behaviour in the first place and ensuring it is sustained over time.

Fostering right behaviour

When it comes to motivating the right kind of behaviour, the U.S. subprime mortgage disaster was a classic case of getting it wrong, fuelled by a series of incentives that perverted conduct up and down the chain. But dysfunctional behaviour arising from faulty incentives isn't limited to the American subprime mess.

It goes without saying that every investor wants their mutual funds to get the best possible returns. Sometimes, though, a problem arises as funds that obtain superior returns attract a flood of money. Some get so big that their performance suffers, as the funds lose the flexibility to find the opportunities that got them the original returns.

As a general rule, managers of funds want them to get bigger, since they become more profitable as a result. The difficulty derives from incentives. The revenue model for most mutual funds is a flat percentage of assets, regardless of whether a fund does better or worse than average, so bigger is better in terms of profitability, even if it risks compromising investor returns.

To their credit, there are cases where investment managers have closed funds to new investors at a point where more money would compromise performance - but there are at least as many instances where such funds keep accepting new money, attracted by higher management fees.

To deal with this, pension funds and the highest-net-worth investors dig deep when hiring money managers to determine the threshold at which they will shut down funds to new money. Along the same lines, they also consider how much net worth the managers have in the funds they manage. Indeed, some fund companies prohibit their managers from owning individual stocks, limiting investments to their own and other funds run by that fund company.

In last year's annual letter to investors, Vancouver money manager Tim McElvaine closed with the words: "I am not a pimp. I invest the bulk of my net worth right beside that of my investors."

Sustaining right behaviour

So, the first step is getting the right kind of behaviour. Then you need to ensure that behaviour is sustained over time.

Much of last year's financial crisis was driven by incentives that made people focus on the short term. To address this, some Wall Street firms have started paying out bonuses over a number of years, to get traders and investment bankers to think twice about doing things that may lead to windfall profits and bonuses today but big problems tomorrow.

Incentives also come into play when it comes to investment managers. The standard compensation for hedge fund managers is "2 and 20" - 2 per cent a year in management fees to cover operating costs, plus 20 per cent of profit above a certain threshold, typically 6 per cent. That model can lead some hedge fund managers to do whatever it takes to maximize profitability in the current 12-month period, even if it may lead to problems down the road.

As a result, there's a move afoot to require hedge fund managers to leave half their bonuses in the funds they manage, to ensure their interests are aligned with those of the other investors.

Similarly, there's a push to compensate money managers for performance over a period of three to five years rather than the most recent 12-month period - and to encourage them to put part of their bonuses into the funds they manage.

So don't hesitate to ask questions before investing in a fund. Talk to your adviser about whether its size could hurt returns, how much of their own money the managers have invested in it, the policy on personal investments by managers outside the fund and how managers are paid.

Experienced advisers and investors know that the expression "Compensation drives behaviour" does hold true - and they make it a priority to ensure that the managers entrusted with their money have their interests squarely aligned with those of investors.

© 2007 The Globe and Mail. All rights reserved.

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