Gaming Performance Fees by Portfolio Managers

Any compensation mechanism that is intended to reward superior investment performance can be gamed by managers who have no superior information or predictive ability; moreover they can capture a sizable amount of the fees intended for the superior managers. We derive precise bounds on the size of this coat‐tail effect and show that it remains substantial even when payments are postponed, bonuses are subject to clawback provisions, or outright penalties are imposed for poor performance. This impossibility result stands in contrast to performance measures, some of which are invulnerable to manipulation. Disciplines Statistics and Probability This journal article is available at ScholarlyCommons: http://repository.upenn.edu/statistics_papers/561 Gaming Performance Fees by Portfolio Managers Dean P. Foster* and H. Peyton Young** This version: March 19, 2009 *Department of Statistics, Wharton School, University of Pennsylvania **Department of Economics, University of Oxford Acknowledgements: We are indebted to Pete Kyle, Andrew Lo, Andrew Patton, Tarun Ramadorai, Krishna Ramaswamy, Neil Shephard, and Robert Stine for helpful suggestions. An earlier and more informal version of this paper was entitled “The Hedge Fund Game: Incentives, Excess Returns, and Performance Mimics,” Wharton Financial Institutions Center Working Paper 07‐42, University of Pennsylvania, 2007.