Asset managers who are compensated according to the performance of their funds are likely to take on more risk than their flat-fee counterparts, according to researchers. 

An incentive of higher pay for strong performance should point to an alignment of interests between managers and shareholders for better fund returns, wrote Tianna Yang of University of Manchester and Wenxuan Hou of the University of Edinburgh Business School.

Correlations between risk-taking tendencies and incentivized pay were even stronger for alternatives and emerging market funds, the study found. 

However, the opportunity to up their compensation tends to also motivate managers to pursue riskier strategies, the authors found. This included increasing fund leverage, according to the study of more than 2,500 US closed-end funds between 2006 and 2009. 

A 0.1% increase in pay-performance sensitivity (PPS) raised fund return volatility by more than 0.5%.

Correlations between risk-taking tendencies and incentivized pay were even stronger for alternatives and emerging market funds, the study found. A 0.1% uptick in PPS increased alternative funds’ return volatility by nearly 1.3% and emerging markets’ by 1.2%.

“Fund risk-taking behavior is positively affected by fund PPS, which indicates that the increase in the value of the manager’s compensation outweighs the negative effect increased volatility has on her expected utility,” Yang and Hou wrote.

However, not all managers incentivized by performance-related pay took an additional risk. Those whose compensation contracts were sensitive to and/or correlated with the parent firms' stock price tended to reduce their risk instead.

Furthermore, the authors argued that firms with higher fund risk awarded greater performance incentives to motivate risk-averse managers to select “optimal” investments.

Riskier firms may also prefer higher PPS, the researchers noted, because of an information asymmetry between managers and shareholders regarding investment selections.

“This information asymmetry is more severe in riskier funds because it is more difficult to monitor the manager’s actions in the case of funds with higher investment risk, which can induce an adverse selection problem such that the fund manager benefits at the expense of the shareholders,” Yang and Hou said.

More performance-dependent pay would push managers to be extra sensitive to investment returns and “alleviate the selection problem.” 

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