Carrot and Stick: A Role for Benchmark-Adjusted Compensation in Active Fund Management

73 Pages Posted: 26 Sep 2016 Last revised: 6 May 2022

See all articles by Juan M. Sotes-Paladino

Juan M. Sotes-Paladino

Universidad de los Andes, Chile

Fernando Zapatero

Boston University - Questrom School of Business

Date Written: May 4, 2022

Abstract

Investors delegating their wealth to privately informed managers face not only an intrinsic asymmetric information problem but also a potential misalignment in risk preferences. In this setting, we show that by tying fees symmetrically to the appropriate benchmark investors can tilt a fund portfolio toward their optimal risk exposure and realize nearly all the value of managers' information. They attain these benefits despite an inherent inefficiency in the choice of the benchmark, and at no extra cost of compensating managers for exposure to relative-performance risk. Under certain conditions, benchmark-adjusted performance fees are necessary to prevent passive alternatives from dominating active management. Our results can shed light on a recent debate on the appropriate fee structure of active funds in contexts of high competition from passive funds.

Keywords: Portfolio delegation, benchmarking, fulcrum fees, asymmetric information, passive management

JEL Classification: D82, G11, G23

Suggested Citation

Sotes-Paladino, Juan M. and Zapatero, Fernando, Carrot and Stick: A Role for Benchmark-Adjusted Compensation in Active Fund Management (May 4, 2022). Available at SSRN: https://ssrn.com/abstract=2143838 or http://dx.doi.org/10.2139/ssrn.2143838

Juan M. Sotes-Paladino (Contact Author)

Universidad de los Andes, Chile ( email )

Chile

Fernando Zapatero

Boston University - Questrom School of Business ( email )

595 Commonwealth Avenue
Boston, MA MA 02215
United States

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