Performance fees are one of the more puzzling aspects of the fund industry. They are often hailed as a way of best aligning the incentives of fund manager and client yet, in reality, frequently benefit the former at the expense of the latter. Often in an egregious manner. 

Let’s imagine a hypothetical conversation between a professional investor and a potential client:

Investor: “I have developed this fantastic new strategy that can deliver high, uncorrelated returns. The backtests are incredible. All I need is some capital to put to work”.

Client: “That sounds interesting, what would it cost?”

Investor: “I would want to keep 20% of any performance above cash.”

Client: “Okay. What about the cost of providing the capital?”

Investor: “That would be 1.5% a year.”

Client: “So you will pay me 1.5% to gain an economic interest in my large pool of assets?”

Investor: “Err…no. You will pay me 1.5% for it.”

Client: “Right. And what if the strategy goes wrong?”

Investor: “I am afraid that’s all on you.”

Client: “Sounds great, where do I sign?”

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If we developed our own high conviction investment strategy and sought to make it as lucrative as possible (for ourselves), we would want access to a large pot of assets (ideally somebody else’s) and to participate directly in its performance.* Getting paid a healthy annual retainer would be the cherry on the cake.

Is it unreasonable to suggest that fund managers levying performance fees should actually be paying clients for gaining access to sizeable asset pools? Perhaps, or maybe it is just unrealistic (the lights need to stay on). Clients are, however, providing the necessary capital, bearing the vast majority of downside risk and often paying out fees for volatility. Hardly a textbook example of incentive alignment.

While there has been some evolution in how performance fees are structured, the pace of positive change is slow and certain areas seem to be moving in the opposite direction.** We should not be surprised at this given how asymmetric the benefits and costs can be, and how they often they provide reward for luck or even simple market exposure, rather than skill. Never give up on a good thing!

Of course, it is a free market, asset managers can set their own charges and clients have the agency to decide if the terms are attractive. I would just encourage everyone to think carefully about how well-aligned their incentives really are.  

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* This would also be true for someone who had no investment skill.

** There are better and worse ways to structure performance fees. Too many fall into the latter group.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.