Peer versus Pure Benchmarks in the Compensation of Mutual Fund Managers

Abstract

We examine the role of peer (e.g., Lipper manager indices) vs. pure (e.g., S&P 500) benchmarks in fund manager compensation. We model their impact on manager incentives and then test those predictions using novel data. We find that 71% of managers are compensated based on peer benchmarks. Consistent with the model, peer-benchmarked fund managers exhibit higher effort generating higher gross performance and collect higher fee income. Analyzing advisors’ choice between benchmark types, we show that peer-benchmarking advisors cater to more sophisticated and performance-sensitive investors, and are more likely to sell through direct channels, consistent with investor heterogeneity and market segmentation.

Keywords: mutual funds, fund manager, managerial compensation, incentives, benchmarking, peer benchmarks, closet indexing

JEL Classification: G11, G23, J33, J44