Fee Speech: Adverse Selection and the Regulation of Mutual Funds

New York University, Center for Law and Business, Working Paper No. 98-020

39 Pages Posted: 11 Sep 1998

See all articles by Sanjiv Ranjan Das

Sanjiv Ranjan Das

Santa Clara University - Leavey School of Business

Rangarajan K. Sundaram

New York University (NYU) - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: April 1999

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

Suggested Citation

Das, Sanjiv Ranjan and Sundaram, Rangarajan K., Fee Speech: Adverse Selection and the Regulation of Mutual Funds (April 1999). New York University, Center for Law and Business, Working Paper No. 98-020. Available at SSRN: https://ssrn.com/abstract=119928 or http://dx.doi.org/10.2139/ssrn.119928

Sanjiv Ranjan Das (Contact Author)

Santa Clara University - Leavey School of Business ( email )

Department of Finance
316M Lucas Hall
Santa Clara, CA 95053
United States

HOME PAGE: http://algo.scu.edu/~sanjivdas/

Rangarajan K. Sundaram

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0308 (Phone)
212-995-4233 (Fax)

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