Incentive/Profit Fees Crystallization Frequency

TSWP · Post by **TSWP** » Thu Aug 13, 2015 4:28 pm

I have recently read a paper that discusses the various impacts of the frequency used by funds to set the new watermark and consequently calculate their fees. Part of my interest in this topic derives from the fact that I am trying to launch my own first fund and thus I am wondering about the best possible fees structure to propose to prospects (5/44 like RenTec, I know, if just one was RenTec...).

Seriously, here is the paper link:

Crystallization – the Hidden Dimension of Hedge Funds' Fee Structure

(I also have a version with the tables and figures, .pdf format, email me privately and I can forward it to you).

The curiosity I have, my question, is this:

has any of you made any study about the different returns that you could achieve varying the crystallization frequency, for example charging incentive fees to investors every month vs. quarterly vs. yearly?

Which frequency do you find more convenient for both you and the investor? (assuming you care about both).

Do you find investors may be put off by a monthly fee as it would seem too frequent and possibly skewed in the fund's favor by capturing short-term returns as soon as possible to cash in before the inevitable drawdowns?

If you are willing to share any thoughts, or comment the attached paper it would be great.

Thank you.

goldorak · Post by **goldorak** » Thu Aug 13, 2015 4:40 pm

The higher the performance the higher the frequency incentive fees should be crystallized. Otherwise what is the incentive to take risk the last 6 months of the year?

goldorak · Post by **goldorak** » Thu Aug 13, 2015 7:23 pm

Actually I forgot to mention one thing. The incentive for managers is to have their incentive fees as long as possible too.

As long as you have uncrystallized accrued incentive fees, your volatility is artificially reduced by the percentage of incentive fees (often 20%). That makes you look so much better from a sharpe ratio perspective... Chew

TSWP · Post by **TSWP** » Thu Aug 13, 2015 8:05 pm

> Otherwise what is the incentive to take risk the last 6 months of the year?

Yes, that is what I have thought.

I wonder if investors would accept a variable frequency crystallization scheme based on performance, probably not.

TSWP · Post by **TSWP** » Thu Aug 13, 2015 8:09 pm

> As long as you have uncrystallized accrued incentive fees, your volatility is artificially reduced by the percentage of incentive fees (often 20%). That makes you look so much better from a sharpe ratio perspective...

Good thought, so the goal could be to figure out a fee structure that varies the frequency of the crystallization but tweaked to optimize the look of the Sharpe Ratio Cool

goldorak · Post by **goldorak** » Thu Aug 13, 2015 9:24 pm

Well my personal preference in term of performance fee would be the following.

Take a fixed horizon, let's say 3 years. Investors are locked-in over the period. You define a minimal amount that needs to be paid in order for you to run your business.

Now the deal is you take 100% of the returns above a performance of 50% on the interval, nothing except the small fee if you do under 50%.

After three years, counters back to zero and start for a new period.

This would solve so many problems: staff fidelity/compensation, HF/investor incentives, HF/investor goals, and of course sales relationships, reporting and any other a* licking activities.

FDAXHunter · Post by **FDAXHunter** » Fri Aug 14, 2015 5:03 am

Goldorak's proposal is fraught with so many problems and dangers, I don't even know where to start.... So I'm thinking he must be just joking.

TSWP · Post by **TSWP** » Fri Aug 14, 2015 10:50 am

I think the sense of my question in this thread was more along these lines:

has anyone tried FOR REAL a "smaller than QUARTERLY" crystallization frequency and what are the findings? is it better or worse and why...

The study mentioned above finds that most managers use QUARTERLY fees structure, at least on the sample studied, otherwise it's usually YEARLY. I wonder if MONTHLY or BI-MONTHLY has any advantage in practice, not in theory, if anyone had tried it and what was their experience with that.

Or alternatively: have you studied the issue and what are your conclusions, why did you choose to use quarterly vs. yearly or...?

svisstack · Post by **svisstack** » Fri Aug 14, 2015 11:28 am

>> You define a minimal amount that needs to be paid in order for you to run your business.

how you can estimate that on longer term than 6 months?

goldorak · Post by **goldorak** » Fri Aug 14, 2015 2:21 pm

@FDAXHunter: I am not joking at all, and you will have noticed the word "my personal preference" at the very beginning.

But I would love hearing from you what problems would exist in my solution that does not exist in the standard "I take my incentive fee out every year or every quarter".