AN ANALYSIS OF MUTUAL FUNDS AND THE AGENCY PROBLEM

By Mark Jayne, Undergraduate, Department of Economics, lmjayne@ncsu.edu The agency problem between monetary funds, such as hedge and mutual funds, and their shareholders is a serious problem that deserves further analysis. To start, I have built a simple model to model the hedge fund vs. mutual fund situation. Assumptions of my basic model: We are looking at only one time period where investors may change their holdings once. The liquidity of the hedge funds and the mutual funds is the same. () is dependent on only. , the estimator for , is always right, i.e. = . Hedge fund managers obtain their pay solely through profits of the fund.

Based on these assumptions, we have the following consumption functions based off of the notation used in class. !"# = + !"# + + !"# ,

!"! = + + !"! , Where is the salary of the hedge/mutual fund manager = !"! , (, ) is a function that converts the information from monitoring into net money flow entering/exiting from the fund, Hedge fund manager, and Mutual fund manager. Also,
!"(!) !"

> 0,

!" ! !"

< 0, and

!" !,! !"

!"#$% !"#$ !"#$%

< 0. In order to find where the

managers will maximize their consumption, we set the derivatives equal to zero: !"# , = + !"# + !"# = 0 , = !"# !"# !"! , = + !"! = 0

 , = !"! . Since the negatives make the right side terms positive, the hedge fund situation solves the agency problem better unless !"! is significantly higher than !"# (if they are equal, there is still the !"#
!" ! !"

that pushes the right side curve up further).

Although this is a fairly sound argument as to why hedge funds are better able to solve the agency problem, there is a testing issue, as it is almost impossible to find data regarding hedge funds due to their private nature. This is why I shall focus my efforts on analyzing the relationship between mutual fund managers and their shareholders, and try to understand the motivations that are going on behind the scenes. First, I will make some new assumptions: 1. The expected gain per quarter in the market during all scenarios is 2%. 2. The rates of returns of the funds are normally distributed random variables ! ((2%, !"#$!%& )) and the variance term is under the control of the manager (i.e. it depends on how much risk he takes). Consider the following scenario. A potential shareholder is searching for a fund in which to invest. He finds five funds that are in his sector of interest, with corresponding past two quarter cumulative rates of return on their portfolios: 1. 2. 3. 4. 5. TownsBank10% Goldmen Slecks9.5% Bear Returns9% Liebalman Brothers5% Bankrock1%

and decides to invest in only one of them (which is not an unreasonable assumption, as many investors and pension plans tend to stay with one company, especially if they offer a diversified portfolio). Which one will he choose? Previous returns can be a foretelling of future returns (skill may move or skew the normal distribution in reality), and since these five funds are in the same sector, wayward market forces affect all of them similarly. He will try to maximize his possible return, and invest in TownsBank. Since mutual fund managers are incentivized only by cash flows in and out of their funds, this creates a contest (a tournament, per s) such that the mutual fund managers fight it out for the number one slot. Despite that Goldmen performed 17.5% better than Bankrock, they are both placed into the category of loser, as the rational investor will always go for TownsBank (all else equal, who wouldnt want that extra .5%?).

 The issue that I will discuss in this paper is, what will the losers do in the third quarter? For instance, what will Bankrock do, given that the past two quarters turned out the way that they did? Bankrocks manager wants to be the winner just like everyone else, but he is very far behind the others. He has to take measures to increase his current returns by 11% (given that TownsBank makes the expected market return of 2%) in order to be on top. Anyone familiar with the stock market knows that it is fairly rare for people to make a return of 11% in a quarter. However, the riskier the portfolio, the higher the chances that it will make stellar returns (or stellar losses). Therefore, the mutual fund manager at Bankrock will take on more risk in hopes to gain better than 11% and be the winner next quarter. Bankrock is already on the bottom; there is already money flowing out of the fund, and should the risky venture fail, money will flow out of the fund faster. However, if the venture succeeds, Bankrock will be on top, and not only will money stop flowing out of Bankrock, money will flow in, and the gain to the manager from this change will significantly eclipse the possible loss to the manager. In other words, we will create three possible scenarios ( is for expected value): Third Quarter Investment
High Gain

!"#$ + 3!" = !"#$ + 2%

Expected Gain/Loss

3!" = 2%

Bad Loss

!"#$ + 3!" = 2% !"#$

This is the possible returns for the investors/shareholders, where !"#$ is the change in the return because of the risk. The return (change in compensation) for the fund managers third quarter looks somewhat different: !"! , = + !!" The only change in his monetary income (disregarding () for a moment) comes from
!" !,! !"

, which directly affected by the competition between funds, and, although they can

move together, the managers compensation is not directly linked to the returns of the shareholders. This is what creates the conflict of interest which leads to the excessive risk taking. Obviously, this is an issue for the shareholders, assuming that they are risk-averse. This risk taking will be much less of a problem in hedge funds, as fund managers tend to be risk-averse as well (they are people, after all), and the fact that they are slated to gain and lose with the shareholders makes it more likely that they will take a more conservative

 approach. However, since the contest still applies in the hedge fund world, hedge fund managers will still behave in the same manner. Since the percent of gains that a hedge fund manager gets is dependent on the amount of money in the fund, there is still a strong incentive to be the best and attract large amounts of cash flow. In fact, if a specific hedge fund manager is not risk-averse, he will act in an even riskier manner than if he was managing a mutual fund, since he stands to gain so much more from being the best (hedge fund percentage gain fees can be 30% or more). This fact seems counterintuitive to my previous claim that hedge funds have more tools to solve the agency problem. However, the compensation setup still creates a slacking incentive on the part of the mutual fund manager; a fund manager who is not paid based on performance will be less likely to put the extra effort in to find hidden stock gems. Also, for mutual fund managers, there is a powerful incentive to work to find additional investors to invest in his fund (and thus contribute positively to money flow), and that takes away from the managers stock- hunting time. These facts, although not the topic of this paper, will severely eclipse the cost to investors from excess risk. bit: 1. 2. 3. 4. 5. Let us consider an additional competition scenario, where we change the numbers a Scenario 1 TownsBank10% Goldmen Slecks9.5% Bear Returns9% Liebalman Brothers5% Bankrock1% Scenario 2 TownsBank10% Goldmen Slecks4% Bear Returns3% Liebalman Brothers2% Bankrock1%

1. 2. 3. 4. 5.

In both scenarios, TownsBank has the lead, however there is a crucial difference; they are superstars in Scenario 2, beating the number 2 spot by 6%, however, their lead is sliced to only .5% in Scenario 1. This affords for very different behavior on the part of TownsBank. TownsBank knows that Goldmen will take on extra risk in both scenarios in order to become the winner; they have a much better chance of stealing the top spot in Scenario 1. Thus, TownsBanks manager fears for his winning position more than in Scenario 2, and consequently will take on more risk in Scenario 1 than in Scenario 2, even though his position and current rate of return is the same. Suppose Townsbank takes on no extra risk and thus gains his expected rate of return. Then in Scenario 1, TownsBank: 3!" = 2% = 2% + 10% = 12% Goldman Slecks: 3!" = 2% = 2% + 9.5% !"#$ In Scenario 2 TownsBank is the same, but Goldman Slecks: 3!" = 2% = 2% + 4% !"#$

 As we can see, in order for Goldmen to beat TownsBank in Scenario 1, !"#$ > 0.5%, however in Scenario 2, !"#$ > 6% in order for this to happen. Clearly, TownsBanks manager feels much less pressure in Scenario 2, and will take less risky ventures in order to keep his top spot (he doesnt want to lose it all). The TownsBank manager will take as much risk as is necessary to optimize his chances of staying on top. As for testing my hypothesis that the real-world corollary to TownsBank will change his risky behavior based on the status of his followers, I propose obtaining data from multiple years (many, as this will be the n in the regression) and multiple sectors of mutual funds and separating them based on whether, during the second quarter, there is a clear winner in the rankings or not. Then, I propose analyzing the ANOVA of a regression (containing all relevant control variables, such as control for market volatility) to look at the variance of the change in returns to the third quarter for the one distinct winner case vs. the variance of the winners change in returns in the case where it is a close race. In conclusion, I have defined a model that tries to explain the relationship and the agency problem between mutual fund/hedge fund managers and their respective shareholders. Excessive risk taking is a serious issue that affects shareholder wellbeing, as most shareholders are risk averse and wish to minimize their risk exposure. The tournament situation, although able to incentivize managers to do a better job and gain a better return through working harder, is more apt to simply increase the amount of risky ventures by mutual fund managers, since their incentive structure dis-incentivizes working harder to gain better returns (i.e. change the expected value of the return, not just the variance). An extension of this tournament concept may also be applied to the situation where relatively new mutual fund managers are compared to those with longer track records, as one would expect the new managers to take larger risks in order to enhance their short track record (ones with the long track record would do this less, since they have a long track record to protect). This topic lends itself to for further study in another paper.