Hi Guys,
Are fund management fee incentives tightly aligned with optimum investment results for their clients?
No, not often enough. Since risk and reward are always positively correlated for most investment organizations, fund management fees are formulated and charged in a manner that encourages managers to seek risk levels that exceed those of their more conservative customers. Given their fee structures, this observation is valid for both mutual fund managers and for hedge fund managers, but especially so for hedge fund managers.
My assertion is not rooted in the obvious organizational goal to increase the size of the fund’s footprint and profits. Although that goal is paramount to the success of all funds, this posting focuses attention on the specific levels of the fee structure itself. That structure promotes extra risk taking to enhance the management’s rewards, mostly at the expense of degrading the client’s comfort level. It is especially egregious when considering Hedge Fund operations.
Let’s examine two representative fund fee schedules: first the nominal 1.5 % management fee charge for an average actively managed equity mutual fund, and secondly, the so-called 2-20 fees for a typical hedge fund. The 2-20 schedule refers to a 2 % overall management charge plus a 20 % tax on annual profits. Of course the hedge fund assumes no liability for failure, but also yields to zero bonus payoff if its performance is downhill for usually an annual measurement period.
For the purposes of this example I postulated a $100,000 investment, perhaps a slice from a much larger portfolio. This tactic acknowledges the old adage to diversify and not put all eggs into a single basket no matter how attractive or secure that basket might appear.
To make the rewards/penalties more concrete and the analysis more tractable, I’ll assume that the fund management is considering a single, very aggressive investment opportunity that has a 50 % probability of a 50 % gain, but also has a 50 % likelihood of a substantial 50 % loss for the next year. These aggressive projections are made to emphasize potential portfolio impacts. Given today’s hostile environment, a 0 % return on idle cash is postulated; that’s not a bad assumption.
Most private investors would pass on this risky proposition. Many would require projected expected returns to be at least double possible losses given our historic risk aversion. This representative risk aversion profile has been verified by numerous academic Behavioral studies.
But what about assessing the investment prospects from the fund manager’s purview? His reward incentives for gambling on a 50/50 target proposition might prompt him to make a decision that his client would summarily dismiss if left to his own assessments.
I’ll do the numbers for a private investor, for an active mutual fund company, and for a hedge fund operation to identify profit incentives. For illustrative purposes, I will only propose two option scenarios: either a decision not to invest at all, or commit a $100,000 investment to the stipulated risky venture (really an adventure).
I propose to make the decision to invest or not to invest on a Total Expected Return (TER) basis. For all possible outcomes Total Expected Return is equal to the product of Anticipated Return (AR) times the Probability of that Event (PE) occurring summed over all outcomes. In equation format: TER = summation of all (AR X PE) possibilities. The TER is the criterion that will be used as a measure to control the final investment decision.
Maximizing TER does not guarantee a favorable outcome, but it does optimize prospective profits in an uncertain world. It is a rational econometric approach given an imperfect and incomplete information environment. Note that in almost every trade, uncertainty and information asymmetry exists that gives one participant of the trade an edge over the other side.
There is a disjuncture here between customer and fund providers on the evaluations of their respective TERs. For the private investor or fund client, the TER is based on anticipated holdings performance; for the fund providers, the TER is based on various accrued fees since these firms have limited or no skin directly in the game. TER is very much perspective dependent.
Observe that the TERs for the investor or client are calculated separately from the TER for the fund operators. And that difference produces a disparate incentive between the engaged parties when making an investment decision. This is a distinction with a difference; it not only matters, it matters greatly.
I have completed these calculations to demonstrate the disconnect between the TER for a private investor and the TER for a fund agent. The analysis illustrates the asymmetric nature of the reward incentives. I elected not to incorporate these sample calculations in this submittal because they are somewhat mind-numbing.
The conclusion from these analyses is that a substantial disparity exists between fund management incentives (their TERs) and an individual investor incentives (our TERs). That disjuncture encourages fund management to accept risks that a private investor would discard out-of-hand. Economists will always tell you that incentives are a primary motivation for any action; incentives definitely matter.
The bottom-line is that fund fee schedules, especially those of the Hedge fund industry, are not properly aligned with those of their clientele. In many instances, fund managers are persuaded to seek risks that their customers would immediately reject. Improperly constructed incentives often do damage.
This is yet another argument to be as independent an investor as your resources, your agenda, your time, and your skill set permits.
I guess hindsight is always easier than foresight. In retrospect it is apparent that when risks are not mutually shared, the actors in any endeavor will align themselves across a wide spectrum of actions; those confronted with a heavy risk burden will be more conservative while those not so challenged will favor more risky approaches. If individuals perceive themselves as underwater, more risk is an acceptable avenue to full recovery.
Never is the risk exposure asymmetry more evident then in the Hedge Fund/client investment relationship. The Hedge Fund operations assume almost zero risk, yet have the potential for enormous profits. That’s an unhealthy arrangement.
Allow me to close with a quote from Nikita Khrushchev: “Call it what you will, incentives are what get people to work harder.” Even the Communists understood incentive priorities. As wise investors, we should recognize and honor incentive differences when making all our financial decisions
Understanding the importance of incentives and costs for all financial matters are mandatory considerations when constructing and nurturing a retirement portfolio.
Keep it balanced folks. And stay away from Hedge Funds.
Best Regards,
MJG
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