When investing, the fees you pay matter. Fee structures are important because they not only impact your returns but also inevitably dictate how the fund manager will behave with your money. I am seeing more managed funds and investments with a 0% management fee. These fund managers would have you believe that not paying a management fee and only having performance-based fees means that your interests as an investor and their interests as the investment manager are aligned. They will tell you they are not going to be fat and lazy like all the other managers who charge you a management fee because they will only get paid if they perform.
While their argument sounds enticing and has some valid points, I believe a performance fee-only structure on an investment introduces other risks. Risks that need to be contemplated carefully before making an investment. The things I worry about include:
(1) Paying a management fee sustains a fund manager when times are tough. The truth is, unless you’re running a Ponzi scheme or are amazingly talented (which is rare), you are going to have times when markets go against you, and suddenly you are behind your performance hurdle or high watermark. Sometimes substantially behind. If the manager has a performance fee-only structure and the underperformance continues for a period of time, they might suddenly have to worry about their business cash flow—how they’re going to make payroll and cover costs. There is nothing more distracting than that! This adds extra stress and may result in poor decision-making. I would argue that a management fee gives stability to focus on investing when times are tough. When you are behind, this is the time when you need to focus the most.
(2) When the performance is bad, fund flows generally die off, so there are no new funds coming in. If there is no resetting of the high watermark in the performance fee structure, the only way the investment manager can get paid is to get performance back above your high watermark, which could be a long way away. I would argue this creates a massive incentive for managers to take on more risk and to ‘swing for the hills’ to try and get back to the high watermark so they can once again charge performance fees. This is the only way to get out of their mess and get paid.
(3) A performance fee-only structure might not create the incentives you think. I have seen lots of performance fee structures in my time, and the one thing I know for sure is that not all performance fees are created equally. Whether a performance fee is effective depends on how it is structured. A performance fee-only structure sounds good, but a poorly structured performance fee can result in perverse incentives and adverse outcomes for the investor. If your investment only has a performance fee, then you must understand how the performance fee is structured and understand what incentives it might create. If you want to know how a performance fee should be structured, please read my previous post here.
All this said, you shouldn’t pay fees through the nose for an investment. Fee levels ultimately dictate the returns you get in your pocket. Whenever you invest, fees matter, and you need to do the detailed work to understand how they are structured and what incentives they create. Ultimately, investment managers want to be paid, and so the fee structure will help dictate how they behave with your money. At the end of the day, you get what you pay for.
Kind regards,
Shelley Marsh
Outsourced Chief Investment Officer (OCIO) & Founder
Wealth Differently
General Advice Warning: This information is of a general nature only and has been provided without taking account of your objectives, financial situation or needs. It does not represent and is not intended to be personal advice. Because of this, you should consider whether the information is appropriate in light of your particular objectives, financial situation and needs. We strongly suggest that you seek professional financial advice before acting.
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