The draft law recently backed by members of the European Parliament to cap bonuses for Undertakings for Collective Investment in Transferable Securities (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. At the same time, 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 which optimises the outcome for investors.
The latest plan to regulate the remuneration of UCITS fund managers sets an alarming precedent for practitioners. By capping the bonus, it potentially limits the incentives which are designed to align the interests of investors and fund managers alike. 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. In an attempt to retain them, employers may be forced to raise their fixed salary and thereby increase the firm’s operational leverage and overall business risk. If they do not compensate for the cap, fund management companies in Europe managing UCITS may be placed at a disadvantage to their competitors in other regions when chasing top talent. 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 EUR 6 trillion in investments is vast and competitive; it does not require more regulation, say most fund managers.
Many regulators see the situation differently, preferring to focus on limiting risk rather than maximising returns. According to the members of the European Parliament 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 policymakers’ belief that an incentive beyond a bonus of 100% becomes perverse, either by encouraging excessive risk taking or unfair gouging of investor wealth.
Complicating the assessment of these competing views, 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 the question is how to separate the two? Lengthening measurement periods to a few years, using high watermarks and risk-adjusting returns, may select for more skill and provide for clawback, but it would take a long time to gauge success with any comfort. Also, much psychological research points to excessive monetary rewards being overrated as motivators. 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, we should acknowledge the public’s concerns and strive to address them.
At the same time, politicians should note that the risk of over-regulation is greatest after a financial crisis. Excessive prescription may lead to creative avoidance or new market failures
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 U.S. Supreme Court who noted a hundred years ago that sunlight is the best disinfectant. Greater transparency regarding fees, sources of risk and returns, and remuneration would do much to assuage investor concerns.
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