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Thursday
May052011

Performance related fees: Be careful what you wish for!

As an idea, performance related fees (PRF) tend to be very popular with trustees.  But we believe that generally this is misguided.  Here’s why: 

  • You don’t need to further incentivise fund managers

Most fund managers I know are aggressive, testosterone-fuelled competitors.  And that’s just the women.  Part of the attraction of being a fund manager is putting (your) money where their mouth is.  Even if money was not at stake most fund managers will still be desperate to “win”; and the fund’s performance is the way the score is kept.

In any case, as individuals, almost all fund managers will be receiving performance related bonuses even if you are not paying the organization performance related fees.

As organizations, fund management houses are already highly incentivised to outperform.  Those that underperform tend to lose clients and hence profits. 

  • Even if you could, it wouldn’t do you any good

In most fields, performance related pay or bonuses work well.  They are a good way to encourage people to work harder; and working harder usually yields better results. 

However, we are not convinced that this is true for fund management.  We want fund managers to work smarter rather than harder on your behalf.  We do not believe that working long hours is conducive to better decision making.  Are they really going to be alert enough to spot anomalies in the market at the end of a sixteen hour shift?

Not only might the extra incentive not do any good, but it may actually do harm.  All of us are irrational at some times and to some extent.  However, we want fund managers to be as rational as possible.  The more emotionally attached they are to the decisions, the harder it will be for them to keep cool and detached.  Few surgeons would operate on their own children for a similar reason. 

  • It may create perverse incentivisation

As well as thinking about the amount of incentivisation, we need to be careful about what the fund managers are being incentivised to do. 

Some PRF structures are asymmetric and can create a “Heads I win, Tails you lose” situation.  Obviously this would be unfair and should be avoided.  They can incentivise the manager to take as much risk as possible if they get a share of the upside and little or none of the downside.  This problem can be mitigated by design of the PRF structure.  However, you need to be wary of systems that rely on high water marks.  The only way of recouping the money is if you keep your fund with the manager, because effectively it is taken from future performance related fees.  This will not be attractive if the reason for the underperformance had been a systematic problem with the manager.

The other way it can create odd incentives involves timing.  Imagine you are a fund manager running a fund which is benchmarked against the FTSE All Share with an outperformance target of +2%pa.  Suppose that your performance related fee for each year starts at zero if you perform in line with the index (or worse) and increases smoothly as your outperformance increases, with the maximum PRF attained if you outperform by twice your target (i.e. you outperform the benchmark by 4% that year.)

What action do you think you would take if you were 3% behind the benchmark in late October?  The rational response would be to take as much risk as possible.  You would not get further penalised for your underperformance getting worse.  If you get lucky, you might get the fund back into positive territory.

Now imagine that you’re sitting on outperformance of +4.5% in October.  What would your action be then?  The sensible action would be to take as much risk off the table as possible and spend the last couple of months as a closet index tracker.

It is hard to see how this type of incentivisation would help to align the long term goals of the   trustees with those of the fund manager. 

  • “Hedging bets” in this way is inefficient

One reason we hear for performance related fees is that they act as a partial hedge.  If the fund managers do badly then this is partially mitigated by the lower fund management fees.  Often trustees feel that it would be reasonable to give up the some of the upside if the manager does well to get that mitigation.

We believe that this “hedging” is misguided.  It is more common for fund managers to take too little risk (to give a reasonable chance to meeting their outperformance target) rather than too much risk.  This aspect of performance related fees will exacerbate the problem. 

In the unlikely event that you as trustees want to take less active manager risk, then you could dilute your active funds by having some investments in passive funds. That would be the cheaper option. 

  • It will probably cost you more in the long run

Hopefully your fund manager is good at making rational financial decisions (if not, then sack them immediately).

Fund managers are already financially exposed to their own performance.  Unlike many other areas of human endeavour, there is no way for them to guarantee success; even the very best fund managers will underperform from time to time. 

From their view point performance related fees are much riskier than standard flat rates.  So as rational decision makers, they would only accept performance related fees if they expected the value of their fees to be higher than the usual flat rates, i.e. they expect you to pay more in the long run.

 

It’s not surprising that performance related fees are attractive to trustees.  The desire to punish poor performance is very human.  But we do not believe that it is a rational way to deal with fund managers.  As the trustees of assets on other people’s behalf, we believe that you should avoid the temptation.

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    Performance related fees: Be careful what you wish for! - Opinion pieces - Barker Tatham
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    Performance related fees: Be careful what you wish for! - Opinion pieces - Barker Tatham

Reader Comments (1)

Instead of PRF what is wrong with expecting managers to invest in the same (or a parallel) portfolio to that which they manage for trustees?

You get some such alignment with many LP/GP structures, and also with some managers which operate as partnerships and which make their staff invest (only) in house funds.

While it's not an always essential characteristic in a manager I may be party to appointing, it is among the nicer to haves.

May 5, 2011 | Registered CommenterDerek Scott
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