There is no easy way to say this, but performance fees are not really aligned with investors’ interests.

Most readers by now know I’m not exactly in love with hedge fund managers. However, when I see articles such as this one I am reminded of how little many investors and the press understand about the underlying issues.

The declining popularity of hedge funds in general is a welcome trend, even though the overwhelming reason for this is related to their performance and not to their structural deficiencies. The performance issue is further marred by often comparing hedge fund returns to the general stock market, a very misleading practice since they are completely different animals.

Where real confusion reigns is on the issue of performance fees, which most observers would agree are just “too high”. Aside from the striking incoherencies popping up in various markets (in Italy even some long-only funds will charge a performance fee referenced to cash, calculated monthly and with no high-water mark; highway robbery, really) the concept of performance fee is frequently misunderstood.

There are two main structural – philosophical if you wish – problems with performance fees: first, they are asymmetrical; and second, while they appear to align manager and investor interests, they actually don’t – precisely because they are asymmetrical.

The asymmetry lies in that if things go well (however “go well” is defined) the manager gets paid, but if things go bad the manager is not subject to any claw-back provisions; all of this while the capital at risk belongs always and only to the investor. Hedge funds have attempted to remedy this glaring disconnection by instituting the concept of high-water mark, but when you think through its methodology this turns out to be a low-water mark for fees collected by the manager. And, of course, this is on top of the fixed charge.

The alignment issue crops up when you go beyond the higher-returns-for-me-equal-higher-returns-for-the-manager smoke and mirror trick. While the statement is unquestionably true, it is also true that precisely because of the above-mentioned asymmetry managers have no real downside as they practically possess an option. And options tend to have a funny effect on people’s motivations (especially options for which no premium was disbursed), including but not limited to compelling them to take risks with high potential payoffs.

If these arguments don’t resonate with you, you are not alone: many think that costs are irrelevant if the returns are satisfactory. This however points to perhaps the most insidious structural deficiency in the whole issue of performance-linked compensation in asset management: if higher returns are associated with higher risks, it follows that your net return after fees is undercompensating you by at least some margin for the actual risk you have taken. The question of course is: what is that margin?

We rarely, if ever, get an answer to that question, but you can get a feel for it by asking your hedge fund (or performance-fee compensated) manager a simple statistic: what percent of the total return did I get? Make sure you sit down for the answer.

-Photo Sources-

Cover: http://www.smh.com.au/money/investing/smoke-and-mirrors-behind-performance-fees-20121008-2789i.html

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