Do Portfolio Manager Contracts Contract Portfolio Management?

Lee, J.H., Trzcinka, C., & Venkatesan, S. GRSS0822019

Research Retrieved June: 2019

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In order to minimize agency costs, institutional investors hire portfolio managers relying on performance-based contracts. In fact, the vast majority of mutual fund managers have variable compensations based on his or her relative performance with respect to a specified benchmark. However, these contracts are asymmetric because managers are not penalized for under performance, which creates incentives for them to take on additional risk in their investment decisions. The authors focus on mid-year risk-shifting, namely asset managers that take additional risk in the second part of the year. The authors hypothesize an inverse relationship between risk-shifting and the distance between an individual manager’s performance and benchmarks. Moreover, researchers hypothesized that managers will engage more in risk-shifting in times of poor performance.

Key findings

  • Mutual funds that report mid-year performance close to their benchmark increase the risk of their portfolio in the second part of the year.
  • Mutual funds that report very poor performance display lower risk shifting. For the managers of these funds, the probability of being fired outweighs the incentive to take on more risk that derives from their contracts.
  • Mutual funds that have performance-based compensation display mid-year risk shifting. Whereas, mutual funds that do not have a performance-based compensation do not display risk-shifting. This suggests that the contract structure does not incentivize the managers to take on additional risk.
  • Relying on matching techniques, the authors are able to confirm the causal effect of mid-year performance and compensation structure of the contract on the risk-shifting decision.


The paper shows that the option-like feature of a performance-based contract creates an incentive to engage in mid-year risk shifting. In fact, managers that are compensated by performance-based contracts shift the volatility of the fund to maximize their remuneration.