Top 400 Asset Managers: Bonus caps for fund managers
Proposals to cap UCITS managers’ remuneration will be counterproductive, according to Nitin Mehta
After dealing with the bankers, the EU assault on bonuses has been extended to
fund managers. While banks seemed like legitimate targets for limiting systemic risk, taking aim at fund managers is more perplexing.
The draft law recently voted in by MEPs to cap bonuses at 100% of salary for UCITS fund managers in Europe sets up another tussle between those who favour free markets and those who believe that greater regulation is required to protect investors. At the core of this new debate is an old dilemma: should buyers and sellers be free to contract as they wish, or should governments limit these freedoms in order to safeguard the interests of buyers? More importantly, what should be the proper balance between these competing forces?
The global financial crisis and the resulting erosion of trust may have given regulators the upper hand but both sides have some valid arguments. While investment professionals may be naturally inclined towards free markets, their desire for economic efficiency makes good sense. Also, regulators can point to apparent market failures and therefore lean towards paternalistic protectiveness, often in a search for social justice. Properly informed legislative processes should aim to strike a compromise that optimises the outcome for investors.
However, the latest plan to regulate the remuneration of UCITS fund managers sets an alarming precedent for practitioners. They point out several concerns in the proposal.
A bonus based on performance typically aims to align the interests of the fund manager with those of the client – outperformance rewards both. Therefore, a bonus cap could potentially dilute the incentive and therefore limit the alignment, to the detriment of the fund manager and the investor.
Since remuneration is generally correlated with the marginal productivity of individuals, a cap may reduce the potential earnings of star performers and lead them to go elsewhere so that UCITS investors would not have access to their talent. Rather than protecting investors, they may be left with the least able or ambitious managers. If employers do not compensate for the cap, fund management companies in Europe managing UCITS may be placed at a disadvantage to its competitors in other regions.
To pre-empt such an outcome, employers may be forced to raise their best managers’ fixed salaries and thereby increase the firm’s operational leverage and overall business risk. In the long run, the higher risk would need to be covered with higher income drawn from fees. So, perversely, the bonus cap could lead to greater costs for investors.
Given such an outlook, many expect that fund managers will simply resort to more creative ways to pay their fund managers so that the bonus cap is avoided. For example, a share of the firm’s profits based on investment performance could be distributed to mitigate the limits of a cap. A bonus cap would achieve little.
Many fund managers point to all these possible negative outcomes as reasons for abandoning any attempt at limiting bonuses. Moreover, they decry what they see as an increasing encroachment of regulation on private arrangements which do not pose any systemic risk comparable to banking. The UCITS market for €6trn in investments is vast and competitive; it does not require more regulation, say most fund managers.
In any case, earlier proposals under UCITS V already provided for sound remuneration policies for fund managers. These include proper governance for setting the pay of senior officers; the assessment of performance over a multi-year cycle; a proper balance between fixed and variable pay; a deferral of at least 40% of the variable component; and the payment of a significant part of variable pay in shares of the UCITS fund or similar instrument. Together, these proposals provide a useful framework and sufficient protection for investors. By comparison, a bonus cap seems a blunt instrument with possibly counterproductive results.
Some regulators see the situation differently, preferring to focus on limiting risk rather than maximising returns. According to the MEPs proposing the draft law, the UCITS bonus cap aims to “strengthen investor protection and reduce risky speculation”. They agree with fund managers that remuneration “should be always aligned with the investors’ interests and the performance of the fund”. However, they differ on how that alignment is best achieved. Implied in the draft law is the policymakers’ belief that an incentive beyond a bonus of 100% becomes perverse, either by encouraging excessive risk taking or unfair gouging of investor wealth. For example, a manager approaching the end of the assessment period for a performance-related bonus may be tempted to increase the risk of the portfolio in order to improve the chances of significant outperformance. Similarly, given the normal noise in investment performance, good luck due to chance may result in an unfair bonus for the manager.
Complicating the assessment, it is difficult to attribute superior performance in the short-term to either skill or luck. Both sides would agree that skill should be rewarded while windfalls should go to investors whose capital is at risk, but how to separate the two? Lengthening measurement periods to a few years, using high watermarks and risk-adjusted returns may be conducive to selecting more skilful managers and provide for clawback, but it would take a long time to gauge success with any comfort. Also, psychological research indicates that excessive monetary reward is overrated as a motivator. Adding to the burden, empirical evidence of sustained outperformance in investment management tends to be scant. Given its rarity, fund managers would argue for its due compensation without a bonus cap, while regulators would want to ensure that undeserving managers are not unfairly rewarded with investors’ wealth.
The high remuneration of some in finance as reported by the media has contrasted with the painful experiences of savers and investors during the financial crisis. The two have become synonymous in many minds, implying cause and effect. The result seems to be that European politicians have taken it upon themselves to change the social norms for risk and reward. Investment professionals would do well to understand the growing suspicion that market failure was driven, at least in part, by remuneration issues. In order to regain trust, the public’s concerns should be acknowledged and fund managers should strive to address them.
At the same time, politicians should note that the risk of over-regulation is greatest after a financial crisis. Excessive regulation may lead to creative avoidance or new market failures. Therefore, any regulation of bonuses should be proportionate to the risks posed by the individuals and their organisations. Also, the principles behind such regulation should be consistent across all segments of the financial sector.
Perhaps the best way to promote a sense of fairness in remuneration is to make skill and success more evident, as it is with entrepreneurs, sports personalities and media stars. It was Justice Louis Brandeis of the US Supreme Court who noted a hundred years ago that sunlight is the best disinfectant. Greater transparency regarding fees, sources of risk and returns, and manager remuneration would do much to assuage investor concerns.
Nitin Mehta is EMEA director for the CFA Institute