Constant Investor: Do performance fees boost performance?
Fees can be a powerful incentive, but only if done right
Incentives are one of the most powerful, yet underrated, forces at work in almost any human endeavour. Performance fees are a form of incentive and can be powerful drivers of better performance by fund managers. In order to be effective, these fees need to be thoughtfully structured to drive desired behaviour. Firstly, it is important to understand what is meant by “better performance”? Does it mean to maximise long term returns? Does it mean to meet a market return with lower volatility? Does it mean to accept a lower return but to ensure the preservation of capital in almost any market environment?
Without a clear understanding of what performance we are trying to maximise, it is impossible to determine if a performance fee is properly designed to align the interests of the fund manager with the goals of investors in that fund.
At Avenir Capital, we aim to deliver strong, absolute returns over time to our investors while ensuring the preservation of capital. Consequently, we think there are several important elements that should be incorporated in a performance fee structure. Performance fees should only reward the manager if they have first recovered previous underperformance. This is known as a ‘high water mark’, as the previous high level of the fund must be reached before any performance fee is payable.
Managers should also be material investors in the fund or have ‘skin-in-the-game’, to ensure alignment with clients in bad times as well as good. This ensures an appropriate balance between risk taking, in order to generate returns, and risk management, to ensure the preservation of capital. We are always struck by how few fund managers are prepared to eat their own cooking.
The performance fee structure should also have a longer-term orientation to ensure that managers are being rewarded for sustained performance over time and not just short-term results generated more by luck than any real investing skill.
Adrian Warner, Chief Investment Officer at Avenir Capital
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