132 - Is it better to pay management fees or performance fees?

Mental Models discussed in this podcast:

• Incentives
• Skin-in-the-Game
• Accredited vs non-Accredited Investors

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Show Outline

Key Concepts for thinking about compensating a Portfolio Manager

• Management Fees 
  • Management Fees are priced a percentage of the assets under management. 
  • A 1% management fee means that you will pay 1% of your assets being managed to the investment manager regardless of the returns you receive on your investment. 
  • If you have $100k invested at the beginning of the year, you’ll pay $1k in fees, if your investment doubles, and $1k in fees if your investment gets cut in half. (ignoring the weighted average effect)
  • Management fees can be charged to both accredited and non-accredited investors
• Performance Fees 
  • Performance fees are priced as a percentage of the profit earned on investments over the course of a year. 
  • For instance: A 10% performance fee would provide the manager with 10% of the total profits earned during the year. If you invested $100k, and the $100k grew to $200k, then the investment manager would earn $10k. (10% of the 100k gain). 
  • However, if the investment fell to $50k, the investment manager would earn nothing. 
  • Performance fees can be charged only to accredited investors.
• Hurdle Rates 
  • Hurdle rates are often paired with performance fees to ensure that investment managers only earn performance fees above a certain level of return. 
  • For instance: A hurdle rate of 5% would mean that the profit sharing only kicks in after 5% returns have been earned for the year. In our prior example, if you invested $100k that doubled to $200k, then the “profit pool” is instead $95k, because the first $5k is exempt. The investment manager then only earns $9.5k.
• High Water Marks 
  • High water marking is where hurdle rates are compounded across multiple years. 
  • In this case, let’s assume you invest $100k, and the hurdle rate is 5% per year. 
  • In year 1: your investment declines to $80k. You pay no performance fees. 
  • In year 2: Your investment grows to $110k. You still pay no performance fees because despite earning 37.5% rate of return in year 2, the hurdle rate of 5% compounded in each year, so the investment manager only starts to earn fees after 10% (5% + 5%) on the original $100k. So they would only earn returns above $110k in year 2. 
  • In year 3: They only earn performance fee returns above $115k (ignoring compound growth here).
• The Buffett Model 
  • 0 % management fee, 6% hurdle rate (w/high water marks), 25% performance fee 
  • I think this is an attractive setup and I’d prefer to structure any future fund of mine with a similar arrangement. 
  • This is the best alignment of incentives in my view. You don’t get paid for AUM growth (directly), and only get paid for performance that beats a certain hurdle rate. 
  • However, to do so excludes non-accredited investors. Therefore, if I want to serve non-accredited investors I’d have to charge a management fee at least for them.
• What is the right answer then?
  • Non-accredited:
    • You only have management fees. You obviously want a manager willing to charge them, or you don’t get that manager at all.
  • Accredited:
    • Performance Fees may be your instinctual first option. They tend to align your interests with management. However, there are also downsides for you.
      • May encourage managers to take more risk. Unless they beat a hurdle, they don’t earn anything. They’ll never be 100% aligned with you. 
      • Without a management fee, you are limiting yourself to investment managers who are already financially independent and can afford to have years without income.
  • Personally: I would be willing to pay or charge both sets of fees. My ideal setup is the Buffet arrangement: 0, 6, 25%. However, this isn't ideal for all investors. I could see the benefit of a 0, 10, 50% setup. I can see the benefit of only charging management fees (especially for retired investors who are seeking wealth preservation, not growth)
    • As always: The answer is it depends. But, I hope that I have given you the information you need to understand how it applies for you.

Summary:

As an investor, you want to properly align your interests with your portfolio manager. A key consideration is how to compensate and incentivize that manager with either management fees, performance fees, or both.