For many active-fund managers, a primary goal is beating a designated market barometer such as the S&P 500. Tying a manager’s compensation to outperforming a benchmark supposedly aligns the manager’s incentives with investors’ goals.
But there are problems with this system, suggests research by Chicago Booth’s Anil K Kashyap, Arizona State’s Natalia Kovrijnykh, Booth PhD student Jian Li, and London Business School’s Anna Pavlova. When everyone uses benchmarks as incentives, doing so becomes less effective, the researchers find.
Benchmarks are a long-standing feature of the finance world: money managers’ compensation has been tied to these metrics for at least the past few decades. But there has never been a theoretical framework for this widespread practice, even as investors have turned over $100 trillion to the asset management industry and the amount of money tied to benchmarks has exploded.
Should pay be tied to benchmarks? To find out, the researchers created a model that considers the effects of often-used linear contracts, which offer managers a fixed salary as well as compensation on the basis of absolute performance (as in, hitting a defined threshold) and performance relative to a benchmark. Managers can beat their benchmarks by making smart moves in the traditional sense of buying and selling but also by engaging in other strategies such as securities lending to boost returns and trading in house rather than on the open market to cut costs.
Linking compensation and benchmarks, the researchers find, leads to inflated asset prices. When many managers chase the same benchmark, it raises demand for the assets underlying it. A manager who is paid to beat the S&P 500 is likely to buy shares of the companies in the index, and many other active managers in a similar position will do the same. On top of that, managers of funds that passively follow the index will purchase the same stocks to at least match the benchmark’s performance. This results in higher demand for the underlying stocks, crowded trades, and lower returns.
It can lead to other costs too. Strategies such as lending out securities can boost returns significantly—securities lending alone represented 5 percent of total revenue at large investment managers BlackRock and State Street in 2017, the researchers report. But such strategies can involve risk, and they take time and effort to oversee. A crucial assumption in the model is that managers with larger portfolios have higher costs, Li explains.
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Money Managers: Good at Buying, Not So Good at SellingWhile the current situation isn’t socially optimal, the researchers suggest modifying rather than scrapping it. They conclude that it would be more efficient to lessen the amount of compensation tied to benchmarking by changing the sensitivity ratio. Say an asset manager who beats the S&P 500 by 1 percent is currently rewarded with 0.5 percent higher performance compensation. Changing that 0.5 percent to 0.1 percent would make the payment less sensitive to benchmark-related performance.
It would also behoove investors to lessen the amount of compensation tied to absolute performance, the researchers write. Linking pay to absolute performance does give fund managers an incentive to make money, they acknowledge, and linking it to both absolute and relative performance is ultimately good for both manager and investor. But regulators considering industry compensation rules and investors trying to ensure managers have effective incentives need to take into account the effects of benchmarking on prices, the researchers caution.
They conclude that compensation contracts with better benchmarking practices could lead to lower management fees and help make active management more desirable when compared with cheaper, passive alternatives. Such contracts could even be used to motivate managers to invest more sustainably, the researchers find when they consider how their model could be applied to environmental, social, and governance investing. In current industry practice, investors instruct managers to hold a portfolio with a defined average ESG-rating target, such as four out of five globes, with five globes being Morningstar’s highest ESG score. But it would be more effective to instead give managers benchmarks that put more weight on stocks with high ESG scores, according to the study. “We’re calling for providing incentives through the benchmark design,” says Li. And if the desired ESG benchmark doesn’t exist, she notes, perhaps the industry should create it.
Anil K Kashyap, Natalia Kovrijnykh, Jian Li, and Anna Pavlova, “Is There Too Much Benchmarking in Asset Management?” Working paper, March 2021.
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