Incentive/Profit Fees Crystallization Frequency

[TSWP]

Picking up again this thread, what would any of you say, if you were an investor, if your manager would apply you some sort of profit fee based on "merit" ?



Example:

if your fund as a whole in a year returns 0% to any % that is equal to the current average of the returns of some sovereign bonds out there (say a mix of US, German and UK bonds), you charge no profit fee, only a flat management fee (say 2%)



if your fund as a whole in a year returns 5% to 10% you charge a 20% profit fee + management fee



if your fund as a whole in a year returns 10% to 20% you charge a 25% profit fee + management fee



if your fund as a whole in a year returns 20% to 30% you charge a 30% profit fee + management fee



if your fund as a whole in a year returns 30% to 40% you charge a 40% profit fee + management fee



if your fund as a whole in a year returns => 40% you charge a 50% profit fee + management fee



The profit fee numbers I have presented must be elaborated more precisely, this is just a dummy to give the idea: the larger the return made by the fund, the larger the profit fee but if the profits are below a certain sovereign bond-comparable yearly returns threshold we charge no profit fees to the investor.



Management fee is always charged because it's a way to guarantee to the investor that we can always run the business. We can put a cap on the management fee based on actual expenses, so it does not become a way to make money no matter what the performance is, at the expenses of the investor (that is how it is now, and has been for a long time).



I am trying to align the manager's interest with the investor's interest, as much as that is possible, we know they may be diverging.



Thoughts welcome.

[HitmanH]

Returns encourage you to punt.

There are some US shops out there I know who run managed accounts - and they pay a fee which increases as realised Sharpe does.

[svisstack]

better one year good return then 2 years half of it.

[TSWP]

>Returns encourage you to punt.



Do you mean the investor may not like the idea that you could take more risk than usual to generate larger returns (to create a larger profit fee for yourself)?

[deeds]

svisstack - better for who?



taking risk doesn't usually decompose so simply as a choice between one big bet or two smaller bets whose sum is equivalent



don't returns need to be considered in the context of risk?

[svisstack]

@deeds:



yes i know it i just pushed first thought about this fee schedule setup, dont know anything about his underlying business



his goal is maximize profit from performance fee at the end of the year,

just pointing out that can be possibility to adjust trading behavior by using:

- time to end of the period

- current ytd return generated

- fee schedule structure (performance fee jump points)

- internal knowledge about trading model adjusting possibility



don't know that it can be worth spending time on it, maybe yes maybe not,

it look like incentive to be more volatile at the end of period while being close to performance fee jump point.



and of course its good for investor also because profit fee rate going up with return,

probably investor intention is to maximize total return not drawdown or something else i just dont think about this much

[TSWP]

>There are some US shops out there I know who run managed accounts - and they pay a fee which increases as realised Sharpe does.



Thanks for the valuable input, so they consider Sharpe Ratio as a better proxy to determine the manager's returns vs risk taken.

[TSWP]

svisstack,

to answer your questions:

the reason why I started this thread was to figure out where one could improve the current fees structure, for both investor AND manager



let's say we have 2/20, on average (some say 1.5/15 today, and RenTec is at 5/44).



2% management fee for a 10M fund or a 50B fund it's not the same, as probably the 50B firm does not need all that money to assure smooth running of the business (I know at least 1 50B fund that has a policy to employ <=2 people per 1B AUM, do they need 1B USD/year to run a 100 people business that earn on average a few hundreds K each/year? 50% of that management fee, 500M USD, goes straight in the pockets of the owner of the fund with no benefit for the investor, while a 10M fund is probably struggling to survive with a 200k USD/year management fee)



20% profit fee is a one-size-fits-all, good for the manager sometimes, good for the investor sometimes



it may be worth thinking a different approach, meritocratic or something else, just brainstorming here... input parameters to work on can be crystallization periods, Sharpe Ratio-based meritocracy, returns incentives, else, etc.

[HitmanH]

One other statement (unfortunately) is that if if you're proposing to launch a fund with these fees - beware that LOTS of investors don't like what they are not used to.



If the analyst likes you - but has to explain your wierd fee structure to his investment committiee - it isn't good. Even if there are benefits / protections for the manager - it's not worth the hassle...

[TSWP]

> beware that LOTS of investors don't like what they are not used to.



Yes, I have heard that from a chairman of a multi-B fund. He told me: is better to go with a 2/20, classic fee, no hassles, do not disrupt the status quo, you have nothing to gain from this sort of "fee innovation".





Right now I am elaborating something based in part on comments made by you and goldorak, plus some other ideas I have. If is worth it, when ready, I will post it here, I am thinking something in the multi-year crystallization space, delaying profit fee charges on the years where you underperform the benchmark, with 1-year lock ups and 1-year performance sampling periods, recalculating fee for the whole period from last watermark where you outperformed, but obviously what you just said makes me feel that it may not be a good idea as it will be too complicated to understand for the investor...