Performance-based compensation models for Investment Fund Managers: How Fair?

Performance-based compensation models for Investment Fund Managers: How Fair? - Κεντρική Εικόνα
31 Mar 2016

Positive performance is the desirable outcome of all investment decisions. Professional investment managers struggle to find the ultimate composition of asset holdings in order to enhance their portfolio’s performance and to maximize their own performance based remuneration. Actually, the incentive fee charged on the positive performance is a significant portion of portfolio manager’s income: The “2/20” fee structure is the traditional model employed by managers that refers to a flat 2% annual management fee, and 20% annual fee charged on excess profits. However, since 2008 financial meltdown, funds and discretionary portfolios have experienced a dramatic decline in net assets that compressed portfolio returns and paved the way for more sophisticated fee structures. Fund managers have revised their fee models to overcome poor performance, to meet investors demand for more fair and transparent fee attribution and to comply with stringent regulatory requirements.

An investment fund manager's performance fee is typically calculated over a predefined period, usually a year, and is based on over-achievement of certain targets such as a previously achieved highest NAV level (called High Water Mark) and a benchmark index, floating, or absolute rate of return (called Hurdle Rate). Thus, to be fair, the manager's Performance Fee should be attributed to individual investors for the portion of the overall performance achieved since their purchase of shares. Unfortunately, computational complexity requiring the use of advanced software, has led a number of managers to use sup-optimal performance fee models which are not always fair. 

In the following presentation, we compare the three main performance fee models used today by investment funds, and highlight some of the problems that each encounters:


To conclude, a properly structured performance fee measurement model should align the interests of the manager and the shareholder. While common thresholds such as High Watermarks and Hurdle Rates are usually employed to ensure that portfolio manager earns fees for excess performance , these are not sufficient to ensure a fair fee attribution to investors on an individual level. “Free ride” and “Claw back syndrome” are typical pitfalls for both shareholders and managers when portfolio performance is measured with too simplistic models such as the “Whole of Fund”. On the other hand, more elegant models such as the “Equalization”, resolve the aforementioned issues but are time consuming, administratively demanding and raise operational risk concerns.

Therefore now, more than ever, the timely and accurate calculation of performance based charges has become a prerequisite for regulatory compliance and for the fair fee attribution among investors. To that extent, modern portfolio management software systems provide flexible solutions to overcome computational complexity challenges present in the more advanced methods, while reducing operational risk.