For long-only equity and fixed income investments, the traditional fee structure has been flat rate percentage of assets under management (AUM). Alternative investments, on the other hand, have often layered a performance fee on top of an AUM-based management fee. For example, hedge funds often employ a “Two and Twenty” fee structure, which consists of a 2% base management fee charged on AUM and a 20% performance fee charged on outperformance above a certain benchmark.
In recent years, performance fee structures have begun to trickle into the more traditional asset class investments within separately managed accounts. As some asset owners contemplate broader adoption of such fee structures, it’s important to understand what incentives these fee structures provide to different types of asset managers.
A recent study from Dimensional researchers and Nobel Laureate Professor Robert Merton outlines a robust framework for evaluating various fee structures and highlights some important lessons regarding the effect of performance fees on the incentives of investment managers. Performance fees provide managers a payoff structure resembling a call option: the managers get paid a portion of the profits but do not generally share in the downside. This motivates the use of options theory to assess the value of performance fees. This option-based framework is robust, transparent, and can be applied to complex performance fee structures with different features.
The valuation of fees does not rely on managers’ expected outperformance or “alpha.” Rather, a strategy’s volatility, or tracking error, is an important determinant. This can drive unintended incentives for the investment manager. For example, in a simple performance fee structure the value of manager compensation grows almost linearly with the volatility of the underlying strategy, providing the manager with an incentive to increase the volatility of the returns of the portfolio. Similarly, when performance fees are based on relative performance against a benchmark, the value of the performance fees increases with the tracking error against the benchmark, incentivizing more deviation from the benchmark.
The link between volatility (or tracking error) and the value of a performance fee implies these fee structures may be more appropriate for some investment styles than others. For example, a traditional stock picking manager with inherently high volatility and lower scalability might find performance fees a more preferred way to increase revenues than by growing AUM. On the other hand, investment strategies that seek to capture systematic return premiums such as size, value, and profitability are less amenable to a performance fee structure. Long-term drivers of returns are positive on average but can be quite volatile and go through pronounced periods of underperformance. In periods of such underperformance, a performance fee structure would effectively penalize systematic active managers for staying focused on the premiums they are hired to deliver.