When the absence of incentive fees can give investors an Olympic-sized headache

27 August 2008

Although the Olympics is an “amateur” athletic event, many athletes get one time bonuses from their government or corporate sponsors if they do well. In part, such incentives are designed to ensure the athlete doesn’t just go the games to have a good time. While the Olympic festivities are an experience in their own right, many other athletes with such incentives often forgo competitions if winning seems out of reach or a pyrrhic victory is likely (take, for example, tennis players who skip tournaments to rest a nagging injury or recuperate after weeks of competition).

The incentive to win - whether financial or purely psychological - is arguable what separates athletes from entertainers or performers. But are incentive fees also valuable in asset management?

A hedge fund incentive fee is often referred to as a “free option”. In a 2001 article for the Journal of Alternative Investments, Mark Anson described it this way:

“Investors in the hedge fund own the underlying partnership units and receive payoffs offered by the entire distribution of return outcomes. They are generally risk-averse and dislike higher volatility. In contrast, the hedge fund manager is the holder of a contingent claim on the value of the underlying partnership units. The hedge fund manager, as the owner of the option, receives payoffs only from the tails of the hedge fund return distribution. The contingent claim nature of the incentive fee call option makes higher variance desirable to the hedge fund manager.

“The irony is that investors in the hedge fund actually provide the incentive to the hedge fund manager to increase the volatility of the return distribution for the hedge fund. Furthermore, the higher the percentage of profit sharing, the greater the incentive for the hedge fund manager to increase the variance of the hedge fund’s returns.”

So basically, a hedge fund investor pays a management fee that is analogous to that of a mutual fund (around 2%), plus a free option that is not dissimilar to an executive stock option.

But as we all learned around the turn of the century, these options have a value. If were to similarly “expense” these options, then the overall fees paid by an investor would be, to take a hypothetical example, 2% plus another 2% depending on the volatility of the fund’s return.

Hedge funds could, of course, just charge a 4% management fee. Technically, the investor should be indifferent. But they don’t. And investors don’t demand it either. In fact, research suggests that hedge fund investors are more price sensitive when it comes to management fees than they are when it comes to incentive fees. So thankfully for those investors (many of them sophisticated institutions), the government allows them to freely negotiate fees.

Mutual fund investors aren’t so lucky. As we have discussed before, US mutual funds are barred from charging asymmetric fees - fees that have an upside for the manager, but no downside. Notwithstanding certain tricks used to get around this rule, the market is not able to negotiate any alternative fee arrangements with fund managers.

In a recent article on the sub-prime turmoil, Columbia University’s Charles Calomiris made the following observation about this regulation:

“The typical hedge fund compensation structure is not permissible for other, regulated asset managers. Other asset managers must share symmetrically in portfolio gains and losses; if they were to keep 20% of the upside, they would have to also absorb 20% of the downside. Since risk-averse fund managers would not be willing to expose themselves to such loss, regulated institutional investors typically charge fees as a proportion of assets managed and do not share in profits. This is a direct consequence of the regulation of compensation, and arguably has been a source of great harm to investors, since it encourages asset managers to maximise the size of the funds that they manage, rather than the value of those funds. Managers who gain from the size of their portfolios rather than the profitability of their investments will face strong incentives not to inform investors of deteriorating opportunities in the marketplace and not to return funds to investors when the return relative to risk of their asset class deteriorates.” (our emphasis)

There is no question the aggregate fees charged by hedge funds (explicit plus option value) tend to be higher than those charged by mutual funds. But as Calomiris points out, if the market is willing to pay those higher fees, then freely allowing participants to structure their arrangements may not be such a bad idea after all.