Fee Speech: Adverse Selection and the Regulation of Mutual Funds

Abstract

The Investment Advisers Act of 1940 (as amended in 1970) prohibits mutual funds in the US from offering their advisers asymmetric "incentive fee" contracts in which the advisers are rewarded for superior performance via-a-vis a chosen index but are not correspondingly penalized for underforming it. The rationale offered in defense of the regulation by both the SEC and Congress is that incentive fee structures of this sort encourage "excessive" risk-taking by advisers.

Apart from affecting portfolio selection incentives, however, the fee structure also influences equilibrium welfare levels in two other important ways: (a) through its risk-sharing properties, and (b) through its potential at conveying information about the adviser's abilities. This paper examines a signaling model with multiple funds and multiple risky securities in which all of these effects are present. We find that incentive fees do, as alleged, lead to more (and suboptimal) risk taking than do symmetric "fulcrum fees." Nonetheless, taking into account the other roles of the fee structure, we find under robust conditions that investors may actually be strictly better off from a welfare stand point under asymmetric incentive fee structures. In summary, we do not find much justification for the regulation.

JEL Classification: G12