To read Part I of this article please click here.
carl baconGuest Contributor: Carl Bacon, Chairman, StatPro
Some critics of performance fees make the claim that asymmetric fees in particular encourage managers to take more risk if performance is poor because they have little further downside and considerable upside. This is not my personal experience. Often when in a hole, I’ve observed that managers in effect stop digging and take less risk when performing badly. On the flip side I have observed managers “lock in” outperformance when they have achieved the cap and take much less risk. This obviously reduces the business risk of the asset manager but presumably the client would like the manager to continue talking taking??? risk if they are obtaining good rewards. Risk-adjusted returns such as M2 would help alleviate this problem.
Sadly performance fee arrangements often end in acrimony. For long term agreements the original authors on both sides may have moved on, and if badly written at the point when both partners should be celebrating good performance, relationships can be damaged by a dispute about the size of fees to be paid. Performance fee agreements should be clear, concise and as simple as possible. I would always recommend including a few worked examples to ensure both parties fully understand the agreement. There is a tendency to complicate performance fees with high water marks and variable hurdle rates; frankly the more complex the agreement the more likely interests will be misaligned. Keep it simple. Investor interests are best protected by structuring performance fees over longer time periods, three or even five years.
It always surprises me that endowment or pension funds that are selecting a portfolio of managers to diversify their manager selection risk require performance fees as a matter of principle. I can’t prove it, but my observations over many years measuring the performance of managers with and without performance fees would suggest the implementation of a performance fee does not actually improve performance.
A portfolio manager is either skilled or unskilled. Those extra hours staying behind in the office will not necessarily add to performance. Sufficient constraints and incentives already exist such that managers are always encouraged to deliver good performance with or without performance fees. In order to attract new clients managers must demonstrate a superior, consistent track record, they often have their own money invested and if they have two clients with the same strategy, one with a performance fee and one not, legally they are simply not able to direct their favorable trades through the performance fee client.
Logically the investor is choosing the asset manager. Why if they are skilled in their choice of manager, and choose good performing managers, should they wish to penalize themselves with a higher performance fee? And, if they choose unwisely, reward themselves with a lower base fee for underperforming managers? Worse still, if they are in the majority and merely average, the performance of the good performing managers will offset the underperformance of the poor performing managers leading to average performance overall. But since performance fees are asymmetric in nature the performance fees will more than exceed the advantage gained from the lower base fees of poor performing managers and investors ultimately pay above average fees for average performance. Investors should treat performance fees as a necessarily necessary??? evil, only accepting performance fees to access demonstrably superior managers where a simple base fee is not available.
There is a place for performance fees but if used they should be:
I. Unambiguous and fair to both parties
Unfortunately, many performance fee structures are unfair and ambiguous, asymmetrical not symmetrical, rarely risk-adjusted and frequently complex.