Delegated Learning and Contract Commonality in Asset Management
Michael Sockin and Mindy Z Xiaolan
Review of Finance, Volume 27, Issue 6, November 2023, Pages 1931–1975, https://doi.org/10.1093/rof/rfad011
A salient feature of the asset management industry is that portfolio manager compensation has a similar structure across active mutual funds. In this paper, we examine the pecuniary externalities that arise when active fund manager compensation contracts have common components in a general equilibrium model of asset management. We show this commonality in the compensation structure and loadings on each component across funds reduces asset price informativeness, amplifies the distortions from active managers’ benchmark-hedging demand, and lowers the price of risk in financial markets. This is because contract commonality distorts investors’ capital allocation to active management, and active managers’ information acquisition and trading decisions.
Our analysis has two key implications. First, from a normative perspective, contract commonality increases the rigidity of the active industry size and performance-based fee. As a result, they do not vary enough with financial market conditions compared to a Planner’s economy. Quantitatively, an increase in asset payoff uncertainty increases the size and performance-based fee twice as much in the Planner economy compared to the decentralized economy. Our results show that regulators can improve social welfare by imposing contingent mandates on active manager compensation; for instance, by making performance-based fees more countercyclical, i.e., higher when market volatility is high.
Second, from a positive perspective, the commonality in active manager contracts contributes to the inconsistency of several widely adopted measures of active manager skill. These include Active Share, Return Gap, and expected excess return, or fund alpha. We measure skill as the amount of private information an active manager acquires. This inconsistency arises because contract commonality makes an active fund manager overreact to the changing risk environment in financial markets, amplifying the disconnect between the return on her portfolio and her information acquisition decisions. Consequently, when active managers face similar compensation contracts across funds, it is more difficult to identify skill in active asset management.