rTSR: When Do Relative Performance Metrics Capture Relative Performance?
58 Pages Posted: 30 Apr 2019 Last revised: 28 Sep 2019
Date Written: September 25, 2019
We develop a measurement-error framework for assessing the quality of relative-performance metrics designed to filter out the systematic component of performance, and analyze relative total shareholder return (rTSR)-the predominant metric market participants use to isolate managers' idiosyncratic performance-chosen by boards to evaluate managers. Among firms that explicitly use rTSR in relative performance contracts, 60%-those that choose specific peers-select rTSR metrics that do a remarkable job of filtering out the systematic component of returns in adherence to the informativeness principle. Firms that choose index-based benchmarks retain substantial systematic noise in their rTSR metrics. The choice of noisy benchmarks is associated with compensation consultants' preferences, which are uncorrelated with observable firm attributes. Firms with weak governance are more likely to choose indexes, not because of opportunism, but because they do not adequately scrutinize outside experts' advice. These findings provide novel evidence on why some executives are evaluated on systematic noise and on compensation consultants' impact on firms.
Keywords: Relative TSR, measurement error, systematic risk, board of directors, compensation consultants, style effects
JEL Classification: G30, J33, M12, M52
Suggested Citation: Suggested Citation