Do mutual fund managers have an incentive to perform?

Conventional wisdom holds that, unlike hedge fund managers, mutual fund managers have little incentive to deploy innovative investment strategies in their quest for benchmark-beating returns. After all, hedge fund managers typically earn much of their compensation through incentive fees for outperforming a benchmark or hurdle rate, while mutual fund managers are primarily compensated only through management fees based on the size of assets under management.
Thus, the assumption is that mutual fund managers focus on gathering assets to increase compensation rather than on generating excess returns.
In fact, the conventional wisdom is incorrect. We demonstrate this in “Mutual Fund Outperformance and Growth,” a research paper I co-authored with my academic partners Zakhar Maymin and Philip Maymin that was recently published in the Journal of Investment Management. Our study demonstrates that mutual fund managers who generate excess returns over benchmarks are consistently rewarded with asset growth, which, in turn, boosts their compensation. This on its own is an incentive for fund managers to devise strategies that generate excess returns.
We examined nearly 30,000 mutual funds divided into 54 fund styles over the period from Dec. 1, 1985 to Sept. 30, 2012. The fund classifications ranged from domestic and international equity to municipal bond and money market funds. What we found was that a fund that earns 10% more than the size-weighted average of its peers in the same style group will, on average, realize an extra 5% excess asset growth in the following year. Moreover, this pattern of future excess asset growth of about half the rate of current excess returns holds for all categories with only two exceptions: small funds (under $250 million of assets) of any style and large fixed income funds with more than $2 billion of assets.
Since few mutual fund managers are paid incentive fees for managing money, many people assume they have little incentive to aggressively pursue excess returns.
This notion is in fact false. Fund managers are quite consistently rewarded for excess returns with growth in assets, which boosts management fee income.
Gregg S. Fisher is CIO of Gerstein Fisher and manager of the Gerstein Fisher Funds