Summary

The domain of mutual fund management is characterized by an array of incentives that influence the decision-making of fund managers, the welfare of the fund investors, and, more broadly, the financial markets. These incentives can be categorized into three broad categories: (a) implicit incentives arising from attracting flows and managers’ career concerns, (b) explicit incentives from advisory contracts that investors have with fund advisors and the compensation contracts that fund advisors offer to portfolio managers, and (c) other incentives arising from managerial ownership, family affiliation, organization structures, disclosure regulations, and business ties.

First, implicit incentives could stem from managers’ drive to attract investor flows and enhance their career prospects. Given that fee revenue is typically linked to the value of assets under management, the incentive to attract investor flows stands out as a powerful motivator for fund managers. The convex flow–performance relation creates incentives for managers to engage in risk-taking and tournament behavior to attract flows. Career concerns can also lead managers to adopt suboptimal behavior in both risk-taking and investment.

Second, explicit incentives originate from advisory contracts between investors and fund advisors, as well as compensation agreements between fund advisors and portfolio managers. While theoretical work suggests that option-type performance-based fees should be the optimal compensation contract for managers, empirical evidence reveals that a fixed percentage of fund assets remains the prevalent compensation scheme in advisory contracts. Nonetheless, explicit bonus-type performance-based pay remains the predominant incentive scheme for individual portfolio managers.

Finally, mutual funds operate within a broader context that includes regulatory environments, fund families, and affiliations with other financial institutions. Consequently, a multitude of factors—including peer dynamics, fund family considerations, disclosure regulations, bank affiliations, and business ties—all play a critical role in shaping managerial incentives.