Over the past couple months I have written and talked about management compensation quite a bit. This has led to me thinking about my own compensation recently, and just like with CEOs, I’m not sure if any fee structure is perfect. Non-qualified investors can’t legally be charged performance-based fees so those clients are easy—2% of assets under management (AUM) is what I charge which is pretty standard. More discrepancies come into play with qualified investors ($2 million net worth excluding primary residence) who can legally be charged a percentage of profits that the money manager earns.
The industry standard for hedge funds is 2 & 20. That is, the money manager earns 2% of AUM (the management fee) plus 20% of net profits (the performance-based fee). Thus, if a manager returns 32% one year, the client pays him 2% of assets plus 20% of the net profits, which is 20% of 30%, or 6%. Altogether the money manager gets paid 8% of that client’s AUM that year, and most people would say it was well deserved for such large returns. But what if the overall market gained 35%—does the manager still deserve to be paid so well even though they underperformed the broader market?
A little history
Taking a step back, hedge funds were traditionally meant to have low correlations to the overall market. In theory, they could profit whether the market was up, down or sideways by using a combination of investment strategies—long, short, leverage, equity, bonds, etc. This is partly done through hedging investments to reduce risk, hence the name “hedge fund.” Many of these traditional hedge funds still exist and I think the traditional fee structure (such as 2 & 20) makes more sense for these guys. Even if they get paid handsomely when they underperform a booming market, they’re also profiting in years when the market is down. Their benchmark is not so much the overall market as it is simply showing a profit.
However, many investment firms have a much simpler strategy of long only and no hedging. My firm is not a hedge fund, but if it was the phrase “hedge fund” would be quite a misnomer. I, along with many other money managers, benchmark performance against the S&P 500 or a similar broad index. If the overall market drops 10% and I breakeven, I think that’s a pretty good year (10% outperformance). On the flip side, if the market rises 25% and I gain 15%, I don’t think I deserve to get paid much for that.
What are we incentivizing?
The first issue is the management fee. This gets paid no matter how the manager performs and is usually in the 1-3% area. Management fees can allow money managers to raise a lot of money and then profit no matter what their performance is. Some managers don’t charge any management fee because they claim a performance only fee structure best aligns them with their investors. Warren Buffett (back when he ran his own partnership many decades ago) and now Mohnish Pabrai both use a 0/6/25 fee structure—meaning no management fee, a 6% hurdle rate and then 25% of profits over that 6% hurdle. Mohnish only earns 25% of profits that are above 6%. The argument against this structure is it encourages shooting for the moon. If the manager doesn’t gain at least 6% he or she makes $0. I’ve even heard investors say they don’t like zero management fee structures for this very reason. A management fee guarantees the manager gets paid something every year so they may not feel pressured to take high risk/high return gambles. Something else that can encourage risky bets is a high water mark, especially after a bear market.
A high water mark means a client only pays performance fees when the portfolio is at its peak value. I think an example is the easiest way to demonstrate this. If a client invests $100,000 in me and I gain a net of 20% the first year, that client now has $120,000 which is their high water mark. If the next year I lose 16.67% they’re back down to $100,000. In year three, if I gain 15% I get paid nothing because that only gets the client’s account to $115,000. The account has to get back over their high water mark of $120,000 before I get paid and I only earn performance fees on returns above that mark.
On the surface, it makes sense the manager should have to “make up” any losses before personally profiting. The problem is high water marks can absolutely screw over the money manager during a bear market, even if he or she is outperforming. The below chart demonstrates this using the actual S&P 500 returns from 2007-2010 and then theoretical returns for a money manager.
Assuming the manager employs a high water mark, at the end of 2007 that mark would be $130,000 which he doesn’t again reach until 2010. Notice the manager outperforms the market in every year and only gets paid in 2/4 of them. After losing 30% in 2008 (when the market lost 37% mind you) the manager now has to gain 42.9% just to get back even with the high water mark! I made the returns a very simple +30% or -30% in the above example, but after a big down year (or two!) in the market, it can easily take a manager 3-5 years to get back “even.” If anything encourages a money manager to take big risks it’s after a downturn when he or she is looking at several years of no income if they don’t pull out a miracle. A management fee helps some to negate this issue, but even better is paying a manager for outperformance as opposed to just profits.
Best of both worlds?
I think the best fee structure is a small management fee (1%) plus a hurdle rate based on a benchmark. That is, instead of a fixed hurdle rate of say 6%, the hurdle rate is the performance of the overall market (e.g. the S&P 500). Achieving this hurdle rate is a more difficult task so the performance-based fee is typically much higher (30-50%). Let’s say it’s 40%. If the S&P 500 gains 10% and I gain 30% after my management fee, I’d earn 30% (net profit) – 10% (S&P 500 hurdle) = 20% * 40% (performance fee) = 8%. Including the 1% management fee, it’s 9% altogether. After all fees, the client would gain 22% vs the market’s 10%. Everyone makes a lot of money and everyone is happy.
The problem with this structure is most investors don’t want to pay a performance-based fee when the manager loses money. Flipping the above example around, if the market lost 30% and I lost 10%, I would still earn that same 8% performance fee. Now the client is down 18%—still beating the market by a wide margin but also down more thanks to the performance fee. By the way, a high water mark can still be used in this fee structure, but it works much better than in the more popular fee structures (like 2 & 20 or 0/6/25). The high water mark in this case guarantees the manager is only paid when the client is outperforming. As shown above, the traditional high water mark results in cases where the manager doesn’t get paid even when they’re outperforming. So even though the client will occasionally have to pay a performance-based fee when the manager loses money under a benchmark hurdle rate, it’s also the best way to assure the manager only gets paid when outperforming.
There are a few managers I’ve seen that use a benchmark hurdle rate, but I don’t think it’s caught on because most investors scoff at the idea of potentially handsomely rewarding a manager that lost them money. And quite frankly, money managers want to be paid well when the market gains 20% and they also gain 20% (or even 15%). I wish I could end this by saying I use a benchmark hurdle rate for qualified clients, but I don’t.
My fee structure
When I started Wiedower Capital earlier this year, honestly I didn’t put a ton of thought into the performance-based fee. Every money manager I looked at did some variation of 2 & 20 and I eventually settled on a 1/4/20 structure—1% management fee plus 20% of net profits over a 4% hurdle rate. I thought (and still do think) it’s a good combination of a small amount of guaranteed income via a management fee plus the potential for larger profits from high returns. From the day I started this company though, two things have always bothered me about traditional fee structures like my own:
- I can get paid very well for underperforming the market.
- I can get paid nothing at all for outperformance.
While #1 isn’t fair for my clients, #2 isn’t fair to me. Maybe these two points simply balance themselves out over the long run and I’m wasting my energy thinking about it, who knows. I didn’t discover the benchmark hurdle rate (or think of it on my own) until several months after I started my investment firm or I probably would have started with it. When I first read about it I was immediately drawn to its fairness for all parties involved. If I can convince investors this is the fairest structure (probably a big if), I’d love to switch to a benchmark hurdle in the future. If any readers happen to use a similar fee structure I’d love to hear about your experiences!