How clients can win the gaming game

Abstract

m ow enlightened was the decision of the 8 Department of Labor and the Securities and Exchange Commission to approve performance-based fee arrangements for managers of pension funds? A recent Institutional Investor article states, “Pension officers are turning to performance-based systems because they are fed up with shelling out millions of dollars in fees year after year for money management strategies that can’t even seem to keep up with the market.” (Hawthorne, 1986). Many observers also believe that performance-based fees may create greater incentives for portfolio managers to use their talents for the benefit of the pension fund. This paper demonstrates that incentive fee contracts could lead to results that are quite the opposite of these perceptions. Many performance contracts can create incentives for the portfolio manager to game the contract at the expense of the pension fund. For example, the archetypical performance contract provides an incentive to the portfolio manager to increase the unsystematic volatility of the portfolio and/or target a portfolio beta that substantially deviates from one. Such contracts offer the portfolio manager a riskless arbitrage opportunity that is easy to implement. The client does not have to provide a manager with this opportunity. By appropriately altering the contracts, adding a cap on the maximum performance fee, and instituting a penalty for negative performance, clients can overcome the adverse incentives problem.