Incentive Fees and Mutual Funds

Authors

  • Edwin J. Elton,

  • Martin J. Gruber,

  • Christopher R. Blake

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    • Elton and Gruber are from New York University and Blake is from Fordham University. The authors would like to thank the Salomon Center-Institute of Finance at New York University, and the BSI Gamma Foundation for financial support. We also thank Lipper Inc. and, in particular, Jeffrey C. Keil for supplying incentive fee and fund data. In addition, we would like to thank Deepak Agrawal, Gordon Alexander, and participants in the 2001 meeting of the European Finance Association (Barcelona) for helpful comments. All errors are our own.


ABSTRACT

This paper examines the effect of incentive fees on the behavior of mutual fund managers. Funds with incentive fees exhibit positive stock selection ability, but a beta less than one results in funds not earning positive fees. From an investor's perspective, positive alphas plus lower expense ratios make incentive-fee funds attractive. However, incentive-fee funds take on more risk than non-incentive-fee funds, and they increase risk after a period of poor performance. Incentive fees are useful marketing tools, since more new cash flows go into incentive-fee funds than into non-incentive-fee funds, ceteris paribus.

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