Fee Speech: Adverse Selection and the Regulation of Mutual Funds

The Investment Advisors Act of 1940 (as amended in 1970) prohibits mutual funds in the US from offering their advisers asymmetric incentive fee' contracts in which the advisers are rewarded for superior performance via-a-vis a chosen index but are not correspondingly penalized for underperforming it. The rationale offered in defense of the regulation by both the SEC and Congress is that incentive fee structures of this sort encourage excessive' risk-taking by advisers. This paper uses an adverse selection model with multiple funds and multiple risky securities to study this issue. We find that incentive funds do, as alleged, lead to more (and suboptimal) risk-taking than do symmetric fulcrum fees.' Nevertheless, from the more important welfare angle, we find that investors may be strictly better off under asymmetric incentive fee structures. Thus, there appears to be little justification for this legislation.