Ironically, almost any good fund manager would scrutinise incentive structures very closely when examining the business models of the companies they are invested in and the pay structures of management teams.
In fact, incentives are deemed so important in the world of corporate governance that shareholders typically get to vote on management remuneration schemes each year.
But the industry has a poor track record when it comes to examining our own incentives and asking tough questions, and it has often taken the regulator’s intervention to precipitate change.
The trouble with performance fees
An obvious solution would be to create a tighter link between the fees charged and the performance delivered. Managers would have a keen interest in delivering value by taking truly active decisions, while at the same time ensuring that undisciplined asset growth does not impair their ability to perform.
While performance-based fees sound great in principle, they have developed a terrible reputation in practice. That’s because many structures actually create a “heads we win, tails you lose” proposition rather than a true alignment of interests.
As an illustration, take the typical “two and twenty” hedge fund fee structure. Managers not only collect a 2 per cent per annum flat fee, which comes with all the problems noted above, but they also effectively get a call option on 20 per cent of the upside.
But what happens if a manager produces strong returns in the first few years, and then subsequently underperforms? The client will have paid substantial performance fees in those first years, despite a potentially negative cumulative total return.
Even with high water marks, this can still produce dysfunctional outcomes.
Is there a better way?
In a perfect world, investors would pay nothing until they redeem their money at the end of their investment horizon. At that point, both parties would know precisely how much value was added by the manager and fees could be calculated based on a pre-agreed sharing ratio.
But this obviously doesn’t work in real life because investment horizons can be measured in decades and managers still need to pay the bills in the meantime.
A potential compromise, which some managers have introduced in their UK-based funds, is a refundable performance-fee structure in which the manager is only paid if he or she outperforms. In this type of structure, any performance fees that are earned are initially paid into a reserve rather than directly to the fund management house.
The firm is only entitled to draw from the fee reserve once it has reached a designated proportion of the client’s assets and it is therefore clear that value has been added. Most importantly, this reserve is also used to pay refunds in the event of subsequent underperformance.
