Carrot and stick: A role for benchmark-adjusted compensation in active fund management

Investors delegating their wealth to privately informed managers face not only an intrinsic asymmetric information problem but also a potential misalignment in risk preferences. In this setting, we show that by tying fees symmetrically to the appropriate benchmark investors can tilt a fund portfolio toward their optimal risk exposure and realize nearly all the value of managers’ information. They attain these benefits despite an inherent inefficiency in the choice of the benchmark, and at no extra cost of compensating managers for exposure to relative-performance risk. Under certain conditions, benchmark-adjusted performance fees are necessary to prevent passive alternatives from dominating active management. Our results shed light on a recent debate on the appropriate fee structure of active funds in contexts of high competition from passive funds.