We study the determinants of compensation in the mutual fund industry using Israeli administrative tax records over 2006-2014. The portfolio manager compensation is influenced by fund flows driven by past raw returns. Managers are thus paid equally for fund superior performance as well as for returns that can be traced to the fund’s passive benchmark, with a percentage point increase in either passive or active returns associated with an approximately 1% increase in manager compensation. To explain why mutual fund companies compensate their managers for fund flows and do not “filter out” the passive benchmark component, we present a simple model of compensation in the money management sector. In the model, investors prefer to invest with financial intermediaries they are more familiar with, and manager compensation is determined by the sharing of rents that accrue to intermediaries for offering access to risky returns. The key implication of the model is that investor familiarity with financial intermediaries magnifies the sensitivity of manager compensation and fund flows to past performance. Using proxies for investor familiarity we confirm the predictions of the model. Our empirical results imply that investors’ inability to distinguish between passive and active returns and their preference to invest with familiar intermediaries are important drivers of managerial compensation. The absence of strong incentives to generate superior performance may explain why the average actively managed mutual fund underperforms.
Job Market Paper