POLITICIANS need a pretty good reason for interfering in the way that a business pays its employees. So what was the rationale for a European Parliament committee vote on March 21st to regulate the pay of investment managers by limiting the level of their bonuses?


Is it because the fund-management industry represents a systemic risk to the European economy, like Banks? Some might point to the collapse of Long-Term Capital Management (LTCM) in 1998, which made markets wobble for a few weeks, or to the problems that two structured-credit funds caused Bear Stearns in 2007-08. But these were examples of hedge funds, which are not covered by the proposed cap. (Their turn, along with private equity, may come.)


Even if the funds were a systemic threat the proposal would still be flawed, as an EU agreement last month to limit bankers’ bonuses shows. That will simply encourage banks to replace bonuses with higher base salaries, in turn making it harder for firms to control costs in a downturn. The best way of reducing bankers’ pay in the long run is to insist that banks hold more capital, thereby cutting returns. The higher capital ratios imposed under the Basel 3 regime do indeed seem to be bringing bonuses down.


Do bonuses need regulating because European politicians think fund managers are overpaid? If so, one remedy lies in the hands of their domestic governments, which are free to raise taxes on high earners. A better answer lies in the hands of fund managers’ clients. Fund management is not a monopoly. No one is forced to give money to an active fund manager, someone who picks stocks in an attempt to beat the market and potentially earns a high salary if he or she achieves it. Investors are at liberty to pick a passive fund, one that simply tries to track the index at much lower cost. Over the long term the evidence suggests that the average investor would be better off taking the cheaper option.


Because active managers charge higher fees, they can reward intermediaries such as financial advisers and brokers with commissions when they persuade clients to put money into their funds. The fees of passive managers are too small to share out in this way. Commissions create a conflict of interest that governments can prevent by making sure advisers are paid by clients, not by product providers. The British government did just this in its “retail distribution review”, a set of new rules on financial advisers that came into effect this year. In contrast, the European Parliament voted against banning commission payments last September.


So the proposal to regulate fund managers’ pay looks bad in principle. It looks even worse in practice. One of the parliament’s ideas is that fund managers should eat their own cooking by holding at least half of their bonuses as investments in their own funds.


However, most UCITS are not open to American investors, so many US-born fund managers would not be able to hold units in their funds. As well as being impractical, the ruling may not truly align the interest of managers and clients.


Suppose a manager runs a fund investing in smaller Vietnamese companies. An institutional investor might put only 1% of its portfolio in such a fund in the hope of high but volatile returns.


In contrast, the proposed EU rules would force a fund manager to have a large proportion of his wealth in such a vehicle. That might make the manager more cautious—holding a lot of cash, for example—thereby acting against the best interests of the client.


Luckily, there is a long way to go before this deeply flawed proposal becomes law. First the whole parliament has to approve it; after that it has to pass muster with national governments and the European Commission. Britain, which was isolated when it came to the restrictions on bankers’ bonuses, will get some support from other EU countries with big fund-management industries. But the proposal gives a sense of the mindset of many European politicians. They want to give finance a kicking and mutual-fund managers just happened to be in range.