May 4, 2010
The Perfect Managed Fund Fee Structure
The Perfect Managed Fund Fee Structure
Ok, ‘perfect’ might be stretching the friendship a little, but my post on The General Theory of Fee Relativity generated a surprising number of comments, most of them excellent suggestions on how the status quo could be improved. As I see it, there are three objectives when establishing an appropriate fee structure: attract and retain talented people; incentivise them to act in the interests of the fund investors; and split the spoils fairly between investors and the manager.
I’ve been mulling over previous comments and reckon this is the best fee structure I can come up with:
- A capped base fee equal to the minimum of: a) a fixed dollar amount, or b) a low percentage of assets under management. For example, for our fund the base fee could be the lower of $500,000 or 1% per annum. The idea here is that the manager gets enough income from the base fee to cover its expenses but doesn’t get a windfall gain simply by growing the size of the fund without performing. Obviously, while the fund is small, a fixed fee would be more than a reasonable percentage of funds under management, which is why you would limit it to, say, 1% per annum;
- A performance fee paid for outperformance of a benchmark, either a fixed hurdle or a relevant index depending on the type of fund. This means the manager only gets rewarded if they deliver performance over and above what the investor could achieve through a passive fund or bank account;
- If the fund underperforms its benchmark in any given period, that underperformance needs to be earned back before any performance fee gets paid. If the benchmark is a fixed rate, the hurdle should compound (i.e. you would need to earn back any underperformance from previous periods plus the benchmark return for the period in question);
- Any performance fee gets paid in units in the fund, aligning the interests of the manager with the investors in the fund. The manager cannot sell their ‘performance units’ inside 5 years but they do get to earn an investment return on the performance fees that have been locked up.
- Those performance units can be transferred back to existing investors in the fund if the fund underperforms the benchmark during that five year period. Obviously the investors in the fund when the fee was paid aren’t necessarily the investors in the fund when it’s given back, but the general principle is that, if you’re going to take some of the outperformance, you should give back some of any underperformance.
This is as close as I can get to meeting the three objectives listed above. Any suggestions for improvement?
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Comments
I like it.
I'm not sure about point 5 though. That's an unusual structure. Clawback provisions do exist in asset management structures, but they tend to be found in Private Equity funds, where the fund investors are locked in and therefore equally benefit from the clawback provision.
As you say, the investors in the fund when the performance fee is clawed back aren't neccesarily the investors in the fund when the poor performance was incurred. Somewhat inequitable I think.
Seeing as you are already paying the performance fee in fund units and locking them up for the 5 year period, I think the clawback provision is somewhat redundant.
Otherwise I think it is good. A based fee to cover expenses and not put you out of business; a performance fee justly earned when you outperform the benchmark (important what it is), and an incentive to focus on long-term performance vs. short term peformance due to the performance payments lock-up.
I like your suggestions, Steve. As Stevedarke mentions, clawback provisions for underperformance appear unnecessary given that the performance fee is already locked up for the 5 year period. It would be quite the altruistic / confident fund manager willing to risk his past rewards to protect and grow FUM. That being said, I'd happily put my money into funds that satisfy all 5, notwithstanding long-term performance of course.
Obviously, as the manager, I'd be happy without a clawback. But investing the fee in the fund for five years doesn't necessarily change the asymmetric payoff. If I outperformed by 20% in year 1 and underperformed by 20% in year two, I'd still get the benefit of a nice juicy performance fee (albeit worth 20% less than it was) at the end of five years - despite the fact that net result was no value added.
I wonder about the size of the base fee cap. If it is set high enough, there maybe no great incentive to make the fund perform. It needs to be low enough to make the manager "hungry" rather than "well fed" while still sustaining the operation. Not sure how one would arrive at such a figure but it could make a lot of difference in the long term. There is also the issue of indexing the cap.
From the point of view of the manager, if both points 3) and 5) are adopted, wouldn't you be penalising yourself twice in a period of underperformance? For example, you would be giving units back to investors PLUS setting yourself a higher hurdle for the next period.
Excellent. I'll be giving your fund a serious look in the new financial year.
I understand your point about the asymmetric payoff, but what about the equity side of it? If I redeem my investment in the fund just prior to the end of a performance period in which the clawback provision is invoked, then I have effectively lost out and transferred my share of the previous period's outperformance fee to existing or new investors. Doesn't seem quite right.
You've already effectively included a high watermark provision as well, I'm just not sure a clawback provision is also required.
You may be giving away too much here. You need to make a profit too!
Perhaps you should back-test this against a couple of decades of market returns, do a little Monte Carlo analysis using a range of potential annual fund returns and see what the payoffs would have looked like over the recent past.
A more important question is the benchmark decision - I think in the past you've indicated it's the cash rate, which I still think is not right.
Does it even meet the criteria for a valid benchmark?
- Umabiguous
- Investable
- Measureable
- Appropriate (consistent with the PM's style or area of expertise)
- Reflective of current investment practice
- Specified in advance
- Owned (be aware of and accept accountability for constituents and outperformance of the benchmark)
The problems with performance fees seems to be mainly around short term volatility which without a catch up clause can lead to a performance fee payable dispite the fact that there may have been no net outperformance :(. This is one of the reasons I generally avoid managed funds.
This could have the perverse incentive to increase volatility by taking risks that arn't justified by the reasonable expectation of appropriate risk adjusted returns.
Some possible solutions are to compound the performance hurdles, and apply them to individual unitholders, although that may involve excessive administration.
Another option may be to calculate performance yearly but over longer rolling periods (say 3 years), and use average unit prices over say 3 months at the start and end of each rolling period, to iron out volatility. (oops, that is a problem for a start up fund!)
In terms of attracting good people, I expect we probably want someone running a fund like this to be planning on sticking around for 3 years and prepared to back their judgement over that timeframe.
Steve you are definitely on the right track, although I'm not quite sure on point 5.
My main suggestion would be to use a dual-benchmark system to determine whether a performance fee becomes payable or not. One benchmark should be absolute-return based (eg cash rate) so performance fees only become payable if money has been made for investors. This avoids the scenario where the market drops by (say) -30%, but the fund returns -20% (an outperformance of 10%). Not too many clients are happy paying a performance fee having lost money, regardless of what the index does. The second benchmark should be something like the S&P/ASX200 Accumulation Index. This ensures a performance fee doesn't become payable in bull markets simply because the first benchmark is cash based. For example market is up +30%, fund +20% would result in a 10% underperformance but a performance fee would still be payable because this is above the cash rate. This benchmark should also be an accumulation index to capture dividends payable rather than a price index.
I've thought about dual benchmarks, the problem is that it can be unfair to the manager. Let's say over a two year period the manager generates returns of zero and 30% while the market generates minus 20% and 30%. Despite having outperformed both benchmarks over a two year period, the manager doesn't get a fee because in each individual period they have underperformed one or other benchmark.
PS Most defininitely any benchmark should include dividends.
I mothballed plans to launch my own fund a few years ago, but the fee structure I proposed was very simple:
1. No base fee.
2. An enormous outperformance fee for performance vs the benchmark (in my case I set this at 50%).
3. An underperformance credit that can be offset against future outperformance fees (also at 50%).
4. Progressively tapering redemption fees that go from an eye-wateringly extortionate 15% (for redemptions within 12 months of first subscription) to zero (for funds left under management for ten years), with an automatic zero rate for investors aged 65+.
The ideas behind this are very simple:
1. It means that over the long-run, a mediocre fund manager won't make any money, which is the way it should be. IMO, if you're not creating value for your investors over and above what an index fund would provide, you don't deserve to be paid, simple.
2. Its symmetry ensures maximal alignment of interests between fund manager and investor.
3. It offers the stickiest investors a reward of fee-free funds management (excluding performance fees of course).
4. It rewards sticky investors at the expense of slippery ones (who are the people who are ultimately responsible for the short-termism and numerous dysfunctions in funds management that we have all harped on about ad nauseum).
5. The payoff for the fund manager isn't quite as volatile as it first appears because redemption fees in times of underperformance are higher, and performance fees in times of outperformance are higher, the combination of which mitigates the absence of base fees (although it is nonetheless a highly volatile fee model compared with the industry standard).
6. It should attract the best quality investors (to paraphrase Buffett "you get the investors you deserve").
I can forward you the partially completed PDS if you like.
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