Finally, this refundable fee structure has the added benefit of smoothing clients’ experienced returns, thereby reducing the likelihood that they capitulate and redeem at exactly the wrong time.
It is well established that investor returns substantially lag the returns of the funds in which they are invested - the so-called “behaviour penalty” - in large part because investors tend to invest after the manager has performed well, and redeem after the manager has performed poorly.
By reducing the pain of the drawdowns during periods of underperformance, a refundable fee structure can help investors stand by their long-term investments, knowing that their manager is also feeling a share of the pain.
Of course, no fee structure is perfect. From the manager’s perspective, symmetric fees introduce significant business risk. Relative performance is inherently volatile, yet the manager still needs to stay afloat when short-term performance is poor.
While this is a challenge, it is not impossible if managers build capital reserves that are sufficient to sustain the business through a prolonged period of underperformance.
Remuneration can also be tied to performance to ensure that fixed costs remain low, with bonuses that are also tied to long-term performance and thereby aligned with the client’s experience.
From an operational perspective, there is no question that client-friendly fee structures can be more complicated to implement than a flat fee. However, with technology and automation, we have shown that the additional calculations required do not need to mean there is less transparency, or any additional delays, in performance reporting for clients.
Even if implementation were a challenge, we think that symmetric fee structures provide the best hope of offering real value for money to clients.
By paying performance fees into a fee reserve, rather than to the manager directly, clients are assured that their manager must sustain outperformance in order to receive the performance fees as income and so the temptation to take on unnecessary risk and “swing for the fences” is greatly reduced.
Instead of having adversarial discussions about fees, clients and managers alike can then look forward to celebrating high fees as evidence of superior results. That’s a true alignment of interests.
Refundable performance fees also allow investors to think more creatively about the choice between active and passive strategies. Too often, the knee-jerk reaction among critics of active management is to focus entirely on costs and “the lower, the better” is the prevailing mantra.
