Selecting the Peer Group for a TSR Program: Real Performance or Risky Business?

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The popularity of Relative TSR programs as long-term incentive plans for senior managers is due in large measure to a number of commonly acknowledged assumptions, or “conventional wisdom.”

  • Management will be incentivized to outperform their peers in a given industry when measured by the overall return of their employers’ shares over a fixed performance period. The choice of metric is assumed to align the interests of management with the interests of shareholders.
  • The choice of an appropriate peer group (such as companies in the same industry sector) will neither artificially penalize nor artificially reward participants as a result of overall trends in the broader equity market.
  • Relative share performance against a group of “peers” (competitors or firms with a similar business model) is the primary measure of management success.
  • On the surface, these arguments appear both reasonable and consistent with real-world conditions. When we start to dig a little deeper, some significant questions emerge.

Who are the mythical “shareholders” whose interests we are choosing to inculcate in the management incentive program? What are “they” looking for?

The class of “shareholders” usually defies a simple, uniform description. On one hand, there are institutions which hold the “well-diversified portfolio” of the Capital Asset Pricing Model. You also may have thousands of rank-and-file employees who hold shares in their 401(k) plans. Some shareholders are in for the long-haul, while others may be the algorithms which account for more than half the volume on the NYSE and trade on a tick-by-tick basis. To say that one set of criteria embodies the desires of these diverse classes is a long stretch.

Is total return everything? What about volatility?

Just as every stock is part of an overall market and every firm may be part of an industry index, we expect that in order to realize an increase in return, we must assume additional risk. If the shares of my company are representative of the market as a whole and I choose a peer group comprising high-beta stocks, guess what? I am setting the stage to underperform my peer group. If I as a CEO assume increased risks to boost my expected returns, am I acting in the best interests of my shareholders? The concept of using some form of risk-adjusted return as a benchmark for executive compensation deserves more than a passing thought.

Just what is performance, anyway?

Relative TSR plans may be designed to hedge away most of the overall market risk from the point of view of the participant. In the broader sense, management performance incorporates the ability to cope with events which are beyond one’s control and derive maximal profit from them. Is there a more “objective” measure of management performance than Total Shareholder Return? This is a question which merits the attention of every Director. Perhaps TSR should be augmented by inclusion of additional performance-based, as opposed to market-based, factors.

Subsequent blog posts will examine these factors in greater depth. We welcome your comments and suggestions.

The preceding is presented to provoke thought and encourage discussion. The staff of Montgomery Investment Technology would like to hear from you. Please post your comments here or email us at

About the Author:

Greg is a Derivative Valuation Consultant with Montgomery Investment Technology, Inc. He holds a BS from Carnegie-Mellon University and a PhD in Chemical Engineering with a concentration in Applied Mathematics from Princeton University. His experience spans management at both public and privately held companies, as well as teaching finance at the university level. Greg is a Chartered Alternative Investment Analyst (CAIA) and a Financial Risk Manager (FRM)