Performance Fees, a Poor Incentive?

Performance fees have typically been associated with hedge funds/alternative investment funds. The traditional hedge fund 2% management fee (on AUM) and 20% performance fees (above a fixed hurdle rate or previous rate of return) date back to the early days of these funds, when many pursued high volatility strategies, often previously employed on banks’ balance sheets rather than managing external investor capital.

As the alternative investment industry has matured however, there have been a number of changes to the 1990’s modus operandi. As the market has become increasingly institutional, the range of fund structures, investment strategies, leverage utilised and fee models has developed to reflect this.

A recent paper co-authored by Wei Dei, Robert C. Merton and Savina Rizova, for The Journal of Alternative Investments, makes some interesting comments about the unintended consequences of manager behaviour due to the ability to receive performance fees.

The paper takes a detailed look at the pay-offs of different fee structures, using an option pricing methodology. It is an excellent read for any investor!

However, what caught my eye particularly, were the comments with respect to systematic managers. Some of the remarks were made in the context of long-only or index type funds. However, the central point remains pertinent to our thinking, that the payment of performance fees may encourage higher risk taking at certain times.

We believe that most institutional investors wish to receive consistent returns with no unnecessary implementation costs on a broadly diversified portfolio that adheres to stated investment objectives and, with alignment of interests between the investor and portfolio managers.

This ethos has guided us in pricing our upcoming fund launch.

We simply believe that we can build a more sustainable business, with better aligned interests, where a low management fee is levied and shared equally amongst partners.