Academic journal article Academy of Accounting and Financial Studies Journal

Compensation of Investment Company Advisors: An Empirical Investigation

Academic journal article Academy of Accounting and Financial Studies Journal

Compensation of Investment Company Advisors: An Empirical Investigation

Article excerpt

ABSTRACT

Data about the compensation contracts of open-end investment companies is collected and empirically examined. As expected, compensation is always a function of the NAV of the investment company and, in general, compensation is (weakly) monotonically decreasing in the marginal rate paid on increasing levels of NAV. Less often, the compensation contract is also contingent on the income of the company. In the cases where the method of calculating the income proportion of compensation is identifiable, the compensation is (weakly) monotonically decreasing in the marginal rate paid on increasing levels of income. Interestingly, however, the definition of "cash income" varies across investment companies. In addition, open-end investment companies pay additional compensation (or reduce the compensation paid) as a function of excess expenses, a group fee, and/or performance relative to a benchmark component.

As expected, compensation is contingent (either explicitly or implicitly) on performance. Counter to intuition and the agency framework model developed, the less risky the portfolio (measured by purpose, composition, or size), the more sensitive is the compensation contract to performance.

BRIEF REVIEW OF THE AGENCY MODEL

Agency models generally address the problem of moral hazard. This problem occurs when a decision made by one individual, striving to satisfy personal desires, affects the welfare of others. Furthermore, those so affected cannot observe or directly control the choice made by the individual.

In an agency model, the principal is the owner of a business who, for some reason, chooses not to be directly involved in the management of the firm; instead, the principal hires an agent and delegates decision-making authority for the enterprise to that agent. The owner of the firm might choose not to be involved in the operation of the business because of a desire not to expend effort or because the agent has a comparative advantage (either in resources or ability) in the management of the firm or because of a desire to diversify personal and capital resources. If the principal and agent have different goals, if it is too costly to monitor the behavior of the agent, and if both of the parties seek to meet their own goals, the agent won't act in the best interests of the principal. If the agent has decision-making authority and the agent's choices are not easily observed and controlled, the choices he or she makes are unlikely to be consistent with the objectives of the principal.

Suppose the agent expends effort to improve the outcome of the business. The principal receives the net profit of the operation of the business less the fee paid to the agent. Thus, the principal may receive the benefit of the agent's expenditure of effort through the increase in the profitability of the enterprise. However, the agent is assumed to have some, as yet unspecified, level of disutility associated with the expenditure of effort. Because the agent may or may not, depending on the compensation scheme, receive the full benefit of any increase in effort, the agent may choose a level of effort less than the principal would like. The problem of the principal is to motivate the agent to act in a manner that will be mutually satisfying.

The contract that leads to the highest level of expected utility for the principal may be relatively simple or may be quite complex. If the actions of the agent are perfectly and costlessly observable, the principal can merely reward the agent for the "correct" action and punish the agent for the "incorrect" action. However, it is usually the case that the actions or effort of the agent are not perfectly and costlessly observable. In this case, the incentives for the agent must be aligned in such a way that the agent works in a manner desired by the principal.

Problems arise when the effort or actions of the agent are not perfectly and costlessly observable and the incentives of the agent do not lead to behavior that is consistent with the desires of the principal. …

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