Investing for Better by Daniel Seiler

Author:Daniel Seiler
Language: eng
Format: epub
Publisher: McGraw Hill LLC
Published: 2024-04-15T00:00:00+00:00

There are two types of fee models, symmetric and asymmetric. Symmetric fees are a system by which the manager charges either fixed amounts for services rendered or something known as fulcrum fees, which I explain more below. They are symmetric to the extent that fees depend on whether performance is good or bad.

Asymmetric fee structures offer economic incentives to managers for performing well but do not penalize bad performance. For example, a hedge fund manager might make 20 percent of any returns over a specified benchmark when returns are strong, but is not due a fee if the fund does not outperform the benchmark. Asymmetric fee structures are illegal for mutual fund managers in the United States, but common for hedge fund and private securities managers and a natural choice for these types of “active” strategies.9

To the extent that asymmetric fee arrangements are meant to align managers’ interests with the interests of the owners, the ability of the manager to participate in the gains of a successful, outperforming strategy incentivizes managers to look hard to find benchmark-beating investments. The clear advantage of an asymmetric model is exactly this—it encourages managers to outperform, and its application is transparent and fair.

However, the lack of an immediate economic downside to the manager for weak performance tends to force active managers in a dangerous behavioral trap known as the “other people’s money” bias. In short, if one is playing poker with someone else’s chips—as an asset manager essentially is when using an asymmetric fee arrangement—one has the tendency to make riskier bets. Making risky bets using asset owners’ money is good in the short term at least because if the bet works out, the manager gets a share of the winnings, and if it turns pear-shaped, the only pain for the manager is not being paid. Because the manager is not forced to pay an underperformance penalty, downside exposure has a floor, while upside exposure is theoretically limitless—just like a call option.

The typical hedge fund fee arrangement that sets up asymmetric fees separating the management fee from the performance fee further blunts the downside of underperformance. If a manager underperforms the benchmark, it loses the performance fee but can continue to draw the management fee.

Before you get too upset about the injustice of asymmetric fees for hedge fund managers, realize that hedge fund managers justifiably point out that they are also significantly invested in the funds they manage as well, so they feel the pain of underperformance as acutely as the clients do.

If a manager receiving asymmetric payments continues to underperform longer term, obviously, there is the risk that the client will redeem its investment, which will remove the manager’s cash inflow from the management fee. However, the fact that the return profile is asymmetric on upside and down and favors the manager in the short term shows the complexity of establishing a fee schedule that appropriately aligns the interests of owners and managers.

Mutual fund fee models contrast sharply with those of hedge funds.

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