In my previous post I explored how quality uncertainty for both buyers and sellers of active management created a bloated market structure with homogenous fees and average pricing greater than that justified by average quality. One potential solution to these inefficiencies is the use of performance fees for active management; which, it is argued, brings alignment between fund manager and client, by ensuring that fees are linked to the ultimate objective of the end investor. Performance fees are also said to limit the desire of fund managers to engage in asset gathering – conduct that is detrimental to long-term returns.
Whilst there are optical attractions to the wider implementation of performance fees within the field of active management, it is highly questionable whether they incentivise the correct activities or provide genuine alignment between fund manager and client. It is more likely that they exacerbate harmful behaviours. The main drawbacks are as follows:
Process versus Outcome: The importance of focusing on process over outcomes has become better understood in recent years, and is particularly crucial in active fund management where the randomness and variability of results means that outcomes can be grossly misleading when attempting to discern skill. Despite awareness of this issue, the clutches of outcome bias are difficult to escape and the industry remains obsessed by headline past performance. Linking fees directly to performance inflames the issue – it expressly ignores the quality of process / decision making, whilst delivering substantial rewards for positive outcomes, whether they be driven by skill or pure chance.
Incentives Matter: Although not entirely in unison on the subject, both mainstream economics and behavioural science focus on incentives as a key determinate of an individual’s actions. As Charlie Munger commented: “Never, ever, think about something else when you should be thinking about the power of incentives.” Whilst it may appear that performance fees for active management represent a perfectly aligned incentive structure, this is far from the case. Performance fees create a very singular dynamic – reward is related to outperformance, irrespective of how it is generated. It is naïve to believe that the behaviour of a long-term investor won’t alter based on potential near-term payoffs; it could result in increased risk taking or protective strategies to preserve potential performance fees. Furthermore, the asymmetric nature of most performance fee structures also creates disconnect between the interests of the fund manager and client.
Reference Points Matter: Intrinsically related to the power of incentives is the manner in which reference points can dominate our perceptions and behaviour. Performance fee structures often create reference points for fund managers that are inconsistent with the long-term goals of an investor. For example, based on the lessons of Prospect Theory, we might expect the employment of a high watermark to lead fund managers to engage in more risk seeking behaviour when performance falls below this threshold, than when they are above it. Performance fees can also foreshorten fund manager investment time horizons – whilst their stated investment philosophy might be focused on five year periods, performance fees often create short-term reference points focusing on relative returns over the next quarter or year.
Structural Challenges: Performance fees are difficult to apply in a daily dealing structure in a manner that treats all clients equitably – despite the myriad of methodologies employed. For example, if levied annually, four years of modest outperformance could lead to handsome profits for the fund manager, even if the fifth year is disastrous and returns for the client over the entire period are disappointing (depending on clawback arrangements). Furthermore, fee structures that ratchet the base management charge higher following a prolonged spell of outperformance lead to new investors paying higher fees based on historic excess returns that they never enjoyed.
Active Management Fees are not about Performance Alone
It may sound an absurd contention given that outperformance above some benchmark or passive investment is the ultimate goal of employing active investment management, but the fees levied should not be about performance in isolation. Active management fees should be paid because the fund investor believes that the underlying investment process (in the broadest sense of the term) is of sufficient quality that it materially increases the probability of delivering market outperformance over the long-term. There can be no guarantees – in a random and variable system even good decisions can lead to disappointing outcomes.
It is a misnomer to believe that performance fees bring better alignment between clients and fund managers, in many cases they are likely to encourage behaviours that are inconsistent with investor expectations and even the manager’s own investment philosophy. Performance fees are an unnecessary distraction from what is required to improve the market for active fund management, which is lower flat fees, genuinely distinctive investment approaches and patience.