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Gaming Performance Fees By Portfolio Managers

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  • Dean P. Foster
  • H. Peyton Young

Abstract

We show that it is very difficult to devise performance-based compensation contracts that reward portfolio managers who generate excess returns while screening out managers who cannot generate such returns. Theoretical bounds are derived on the amount of fee manipulation that is possible under various performance contracts.We show that recent proposals to reform compensation practices, such as postponing bonuses and instituting clawback provisions, will not eliminate opportunities to game the system unless accompanied by transparency in managers' positions and strategies. Indeed, there exists no compensation mechanism that separates skilled from unskilled managers solely on the basis of their returns histories.

Suggested Citation

  • Dean P. Foster & H. Peyton Young, 2010. "Gaming Performance Fees By Portfolio Managers," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 125(4), pages 1435-1458.
    • Handle: RePEc:oup:qjecon:v:125:y:2010:i:4:p:1435-1458.
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    File URL: http://hdl.handle.net/10.1162/qjec.2010.125.4.1435
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    Citations

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    Cited by:

    1. Lagziel, David & Lehrer, Ehud, 2018. "Reward schemes," Games and Economic Behavior, Elsevier, vol. 107(C), pages 21-40.
    2. Dean Foster & Rakesh Vohra, 2011. "Calibration: Respice, Adspice, Prospice," Discussion Papers 1537, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    3. Peter Sinclair, 2011. "Deficits, Debts and Defaults - Past, Present and Future," Discussion Papers 11-20, Department of Economics, University of Birmingham.
    4. Dean P. Foster & H. Peyton Young, 2012. "A strategy-proof test of portfolio returns," Quantitative Finance, Taylor & Francis Journals, vol. 12(5), pages 671-683, March.
    5. Olszewski, Wojciech, 2015. "Calibration and Expert Testing," Handbook of Game Theory with Economic Applications,, Elsevier.
    6. Andrew J. Patton & Tarun Ramadorai & Michael Streatfield, 2015. "Change You Can Believe In? Hedge Fund Data Revisions," Journal of Finance, American Finance Association, vol. 70(3), pages 963-999, June.
    7. Mark D. Flood & Phillip Monin, 2016. "Form PF and Hedge Funds: Risk-measurement Precision for Option Portfolios," Working Papers 16-02, Office of Financial Research, US Department of the Treasury.
    8. Foster, Dean P. & Young, H. Peyton, 2011. "A Strategy-Proof Test of Portfolio Returns," Working Papers 11-50, University of Pennsylvania, Wharton School, Weiss Center.
    9. Aikman, David & Nelson, Benjamin & Tanaka, Misa, 2015. "Reputation, risk-taking, and macroprudential policy," Journal of Banking & Finance, Elsevier, vol. 50(C), pages 428-439.
    10. Marcus Miller, 2021. "Choosing the Narrative: the Shadow Banking Crisis in Light of Covid," Open Economies Review, Springer, vol. 32(2), pages 291-310, April.
    11. Thanassoulis, John, 2014. "Bank pay caps, bank risk, and macroprudential regulation," Journal of Banking & Finance, Elsevier, vol. 48(C), pages 139-151.
    12. Marcus Miller & Lei Zhang & Songklod Rastapana, 2017. "Subprime assets and financial crisis: theory, policy and the law," CAGE Online Working Paper Series 340, Competitive Advantage in the Global Economy (CAGE).
    13. H Peyton Young & Thomas Noe, 2012. "The Limits to Compensation in the Financial Sector," Economics Series Working Papers 635, University of Oxford, Department of Economics.
    14. Mark D. Flood & Phillip Monin & Lina Bandyopadhyay, 2015. "Gauging Form PF: Data Tolerances in Regulatory Reporting on Hedge Fund Risk Exposures," Working Papers 15-13, Office of Financial Research, US Department of the Treasury.
    15. Michael Hilmer, 2014. "Bailouts, Bonuses and Bankers' Short-Termism," Working Papers tax-mpg-rps-2014-17, Max Planck Institute for Tax Law and Public Finance.
    16. Sylvain Chassang, 2013. "Calibrated Incentive Contracts," Econometrica, Econometric Society, vol. 81(5), pages 1935-1971, September.
    17. David Lagziel & Ehud Lehrer, 2021. "Transferable deposits as a screening mechanism," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 71(2), pages 483-504, March.
    18. Marcus Miller & Lei Zhang, 2013. "The Invisible Hand And The Banking Trade: Seigniorage, Risk-Shifting, And More," Brussels Economic Review, ULB -- Universite Libre de Bruxelles, vol. 56(3-4), pages 365-388.
    19. David Lagziel & Ehud Lehrer, 2015. "On the Failures of Bonus Plans," Papers 1505.04587, arXiv.org.
    20. Judy Qiu & Leilei Tang & Ingo Walter, 2018. "Hedge fund incentives, management commitment and survivorship," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 32(2), pages 115-142, May.
    21. John Thanassoulis, 2013. "Industry Structure, Executive Pay, and Short-Termism," Management Science, INFORMS, vol. 59(2), pages 402-419, June.
    22. Mark Flood & George Korenko, 2013. "Systematic Scenario Selection," Working Papers 13-02, Office of Financial Research, US Department of the Treasury.

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