Incentives and Mutual Fund Performance: Higher Performance or Just Higher Risk Taking?

Abstract

We study the impact of contractual incentives on the risk-taking behavior and the performance of US mutual funds. We measure incentives using the shape, i.e. concavity, of the fee structure in the advisory contract. Compared to the standard linear fee structure, a concave structure should create a disincentive to take more risk. Our results show that a high incentive contract induces managers to take more risk and reduces the funds' probability of survival. On the other hand, high-incentive funds deliver higher return. The net of these two effects is that incentives increase the risk-adjusted performance of the fund. In particular, the top incentive quintile of funds outperforms the bottom incentive quintile by about 2.7 percent per year. Moreover, the performance of the high-incentive funds is highly persistent. High-incentive winner funds from one year have a positive alpha of 41 basis points per month in the following year. By focusing on the funds' holdings, we show that active portfolio rebalancing is the main channel through which incentives increase performance.