The Hindu Business Line : Compensation, key to align manager-investor interest?

THE US' Securities and Exchange Commission (SEC) is considering a proposal that will require a portfolio manager to disclose his holding in the fund. There is also a proposal to direct funds to disclose the structure of manager compensation. The disclosure requirement is expected to help investors gauge the extent to which the portfolio manager's interest is aligned to that of the investors.

Drawing from the SEC proposals, this article looks at structuring compensation to better align manager-investor interest.

It appears that an employee-stock-option-like compensation structure would be an optimal choice. No doubt, the merits and demerits of this proposal have to be extensively debated before it is adopted by the fund industry.

Stock-option structure: Companies typically offer stock options to their employees as additional compensation. Studies in this area have concluded that such stock option plans do improve employee productivity. Whether the increase in productivity translates into higher shareholder returns is quite another matter.

The reason is that systematic return also drives shareholder returns. This means that market-related factors could well bring down shareholders returns despite substantial improvement in productivity and post-tax earnings.

But the fact remains that the non-systematic or company-specific component of the overall return could be enhanced through optimal employee compensation structure such as the stock option plans.

The question is: Can this structure be replicated in the mutual fund industry?

Need for manager-investor interest: It is a common belief that the existing compensation structure leads to a conflict of interest between portfolio managers and unit-holders. At present, a substantial proportion of the manager compensation is fixed. The variable component may well be linked to short-term fund performance.

This raises doubts in the minds of the unit-holders as to whether a manager structures, within the investment style, a portfolio to enhance the likelihood of earning a higher variable component.

Portfolio managers, on the other hand, argue that they are forced to construct a portfolio with a short-term view because of unit-holder behaviour.

Behavioural finance literature indeed shows that investors typically invest for the long term but monitor their portfolio for short-term performance.

This conflict in investment horizon could force portfolio managers to construct sub-optimal portfolios. This perception gap can be narrowed if managers and unit-holders think long term. This may be possible with a stock-option-like structure.

Compensation design: The option will be structured such that the payoff is based on the fund performance of the previous five years. This is sufficiently long term for unit-holders to ensure that a portfolio manager consistently adds value to her investment style.

The manager will have to pay an option premium upfront. Such a payment is proof for unit-holders that the manager has conviction in his investment style. A Bermudan-style option is preferred because the portfolio manager has to be regularly allowed the right of exercise.

The objective of such an option is to enhance portfolio efficiency. It naturally follows that the payoffs should be based on excess returns. That is, the payoffs will depend on the portfolio manager's value addition to her investment style. Essentially then, the payoffs will depend on the path of portfolio alpha over a rolling 5-year period.

This safeguards the portfolio managers and the investors from broad market movements and concentrates only on the non-systematic returns.

A portfolio manager will not be hurt because of a downturn in the broad market as long as she generates positive alpha. Likewise, unit-holders need not feel that the portfolio manager is being needlessly compensated for systematic returns.

The disclosure of alpha-option compensation is important. The fund should clearly state the method of calculating the payoffs and cash outflows from exercise of the alpha option. Further, the option premium paid and the number of contracts purchased should also be stated.

The compensation structure can be dealt with in detail with adjustments made for fund life and investment style. The point, however, is that the structure itself has to be first debated. This article is intended as food for thought.

(Feedback can be sent to bvenky@thehindu.co.in)

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