We believe that using the right measurement period is of utmost importance for assessing an asset manager's performance. Over the short term, investment results can be biased by factors unrelated to fundamental analysis like political events, excessive monetary policy, under-appreciated corporate strategies, etc. In fact, most asset managers would be the first to argue it is preferable to assess their own performance over a full market cycle. Given that, we decided to use a four-year measurement period to assess value creation.
(Ideally, the first performance fee would be paid at the end of the first measurement period, i.e. four years. However, in practice it may not be acceptable for most managers to wait that long. In that case, rolling four-year periods together with a ramp-up period to phase in over the first three years could be used. Ramp-up factors of 25%, 50% and 75% would be applied to applied to performance fees for years one, two and three, respectively, to prevent those years from having more than a 'normal year 100%' impact on fees. This protects both asset owners and managers.)
In spite of measuring performance over rolling four-year periods, a high-water mark is still necessary to avoid paying more than once for the same outperformance. Using four years does not prevent the occurrence of a good four years followed by bad four years. A simple way to apply the high-water mark concept is by accumulating negative performance fees and applying those against future positive performance fees.
The use of four-year measurement periods greatly diminishes the flaw identified by Mr. Adams in traditional one-year performance fee formulas. Indeed, with a four-year measurement period, a single year cannot alone trigger an outsized payout. Consequently, the need for a fee reserve account and a clawback is largely eliminated.