A better way to structure investment management fees

Few issues in investment management are more contentious than fees. Asset owners are understandably pushing back against entrenched fee structures that have served them poorly for decades, while managers are quick to defend the business models that have traditionally made the industry so lucrative. Fresh thinking is desperately needed to break the impasse.

The two most common fee structures — fixed fees and performance-based fees with high-water marks — both suffer from serious flaws. A better structure is a performance-based fee with a symmetrical refund mechanism that better aligns incentives and also increases the likelihood that the fees paid reflect the value added for clients.

It's not hard to understand why fixed fees have become the dominant model in the industry. In addition to their operational simplicity, fixed fees provide managers with a predictable and highly scalable stream of revenue that grows in linear fashion with assets under management. Because of the high degree of operating leverage — i.e., the manager's costs grow far more slowly than the pace of revenue growth — the incremental profitability achieved from additional assets can be extremely high.

The key problem with fixed fees is ultimately one of incentives. The temptation to pursue asset growth is almost irresistible — even if it means growing beyond the manager's capacity to outperform. Even more powerful than the temptation to gather assets is the imperative to avoid losing them by being different and wrong.

The industry is full of very smart and highly competitive people. But the forces of human nature are simply too overwhelming to resist. The random nature of investment returns is such that there is some probability that even the best managers will perform poorly enough over short-term periods to be fired. Since they cannot control either the measurement period over which clients assess their performance and cannot upgrade their skill level — at least in the short term — the only option left to reduce the probability of getting fired is to reduce tracking error.

The rational strategy for an investment manager running a business with fixed fees is therefore to build a strong distribution platform, avoid making big mistakes by staying close to the benchmark, and grow without bound, even at the expense of investment returns.

Performance-based fees would seem to be an obvious solution. They greatly reduce the temptation to pursue unbridled growth, while also discouraging benchmark hugging. But the predominant performance-based fee structure in use today, which uses a high-water mark, simply introduces another form of incentive misalignment. Clients pay a base fee plus a share of any outperformance, and if performance subsequently suffers, the manager must recover the prior peak before again earning performance fees. While this sounds like a good deal for investors, it's really a “heads we win, tails you lose” proposition. For the manager, the payoff to investment performance is essentially a call option in which the high-water mark is akin to the strike price and the client bears the full downside if things go poorly.

With this in mind, how does the manager maximize this option value? He can't really change the time to expiration; clients will redeem when they want to. He can't change the strike price; the high-water mark is set. And he probably can't change his skill level; if he could, he already would have done so. The only thing left to change is the volatility of the portfolio, even if doing so is not in the client's interest. Indeed, research has shown that even a manager with negative skill is better off increasing portfolio risk under such a fee structure, despite the fact that this is, by definition, a worse outcome for clients.

High-water-mark performance fees are also flawed due to their path dependence. Unless an investor redeems while at their high-water mark, they will have paid a greater portion of the return in fees than the stated sharing ratio. For instance, if the manager produces strong returns in the first few years, and subsequently underperforms, the client will have paid substantial performance fees in those first years, despite a potentially negative cumulative total return. Because very few clients would redeem while at their high-water mark, it is very likely that a client will pay a substantially larger portion of their returns in fees than the headline sharing ratio implies.

It is clear that both fixed and performance-based fee structures do a poor job aligning the interests of managers with those of their clients. Any solution should focus on value-for-money, or the ratio of fees paid to the value added, after fees and expenses, and on maximizing net-of-fee returns.

So what would an ideal structure look like? A practical solution is a refundable performance fee in which the manager shares equally in both good and bad performance. Rather than flowing directly to the manager, performance fees flow instead to a fee reserve, available to be refunded should the manager subsequently underperform. In periods of underperformance, fees are refunded to the client from the reserve at the same rate they are earned. The manager is only able to draw from the fee reserve once it has reached a designated proportion of the client's assets.

While this structure is undeniably less favorable for the manager, the symmetrical nature of a refundable performance fee substantially mitigates the major flaws of both fixed fees and performance fees with high-water marks. First, the refundable fee focuses a manager on achieving superior returns, while discouraging the benchmark hugging and asset gathering that are natural outcomes of fixed fees. Second, it reduces the incentive to take unjustified risks, which can occur with a traditional performance fee. It reduces path dependence and increases the likelihood that the fees paid are proportional to the value added. This refundable fee structure has the added benefit of smoothing clients' experienced returns, thereby reducing the likelihood that they capitulate on their managers at exactly the wrong time.

Matthew R Adams is a San Francisco-based director of U.S. research at Orbis Investment Management (U.S.) LLC.