Date: 11.12.15 Category: Ethics & Professionalism
Using Monte Carlo simulation techniques, Andrew Clare, Nick Motson, Richard Payne, and Steve Thomas compare the effect of three alternative fee structures in their paper Heads We Win, Tails You Lose:
- a fee fixed as a proportion of AUM
- an asymmetric performance-based fee, and
- a symmetric performance-based fee.
Their study identifies a clear incentive mismatch between the interests of investors and managers, and more specifically, that there is no single structure that simultaneously maximises both the investors’ and the managers’ utility.
In fact, the results show that the most prevalent fee structure in the UK market (a fixed fee as a proportion of AUM) is generally the best structure for the manager and the worst for the investor.
Their results give rise to a natural question:
Since investors would prefer symmetric performance-based fees, why don’t more fund managers offer such fees?
- In the majority of cases, investors prefer symmetric fee structures. Investors only prefer fixed fees when they are certain – prior to investing – that an investment manager is very skilled and takes a lot of risk. Conversely, only very skilled managers prefer symmetric fees, as they are keen to share in the investment upside they are capable of generating. Poor or mediocre managers prefer fixed fees.
- The benchmark symmetric fee structure is such that managers retain 50% of any out-performance but must repay 50% of any under-performance. Varying the 50% proportion causes investor utility and manager utility to change in the obvious fashion ie if the symmetric fee falls (rises), investor preference for a symmetric fee structure further strengthens (weakens), and manager preference for the symmetric structure weakens (strengthens).
- Stress-testing the robustness of the model parameters has small effects on the results but leave the basic comparatives and main conclusion unchanged
- An important parameter in the symmetric fee case is the size of the reserve that the investment managers retain, and out of which they pay investors for under-performance when they have not earned enough historical fee income to do so. When this reserve is small, managers are better off in utility terms than if this reserve is assumed to be infinite.
- The converse holds for investors. The imposition of the zero reserve decreases the parameter range over which investors prefer symmetric fees, but symmetric fees still dominate around 80% of the parameter constellations we study and very clearly in situations where tracking error is low.
Heads We Win, Tails You Lose was published by Cass Business School in October 2014.