When making investments, many people know to consider their own budget and risk tolerance, but how many know to consider a fund manager’s compensation package? According to Niklas Hüther, Assistant Professor of Finance at the Kelley School of Business, this factor plays a significant role in a fund’s performance.
During his 2014-2016 postdoc at Duke University, Hüther and his colleagues, David Robinson, Soenke Sievers, and Hartmann-Wendels began to investigate how compensation packages for fund managers in private equity might influence the performance of the funds they managed. They explored two different types of contracts: 1) contracts that compensate managers based on the profitability of the entire portfolio of assets, and 2) contracts that compensate managers based on the profitability of each individual asset within the portfolio.
Many people - investors and analysts alike - assume that, from the investor’s perspective, funds that compensate managers based on the whole portfolio’s profitability perform best, as they allow investors to recoup the value of their assets first, before the manager is compensated. This way, if some assets are underperforming, the investor’s costs are accounted for before the manager is paid. However, Hüther and his colleagues found that the opposite is true: funds with managers compensated based on individual asset performance tend to perform better.
According to Hüther, these managers exhibit several desirable practices, and a tendency toward good, efficient exit decisions. That is, they tend to make deals - sell shares in companies - at a more advantageous market time than their counterparts. Under whole-portfolio compensation, however, managers had distorted incentives for waiting too long or exiting too early, which fosters inefficient behavior.
To calculate performance, Hüther attempted to build upon a preexisting MatLab code which is publicly available on Arthur Korteweg’s homepage. However, as is often the case when working with someone else’s code, he was able to create something that mostly worked, but was full of bugs and errors. Jefferson Davis of the research analytics team of UITS Research Technologies worked with Hüther over the course of several weeks to debug the code. They eventually made a robustness test work, solidifying the reliability of the results.
Hüther’s research shows that existing perceptions about the fund-manager compensation package are not necessarily in the best interest of investors. Though few investors would think to look into the contract design of their potential fund managers, Hüther’s work illuminates this factor as an important consideration in delegated asset management.