2 plus 20 really doesn’t work for clients

There is an endless debate about the fees fund managers charge their clients and how much and what incentive structure is fair. In this regard, I am glad I found a summary of all the experimental research that has been done over the last decade in that area.

Typically, there are three different fee structures that are commonly used in practice:

• A fixed fee, which can be either a fixed amount or a share of the assets under managements but it is largely independent of the investment success of the fund manager

• An aligned fee, where the fund manager earns a fixed fee and invests his or her own money alongside the clients’ money, thus participating in losses should they occur

• A convex fee, where the fund manager earns a fixed fee plus a share of the returns, but does not participate in the downside should returns become negative.

The beauty of lab experiments is  that one can test how fund managers invest their clients’ money in each of these scenarios and if they take on more or less risk than under different fee structures.

The good news here is that fund managers care about their clients. They do invest similar to the way they invest their own money when working under a flat fee. If they are held accountable by clients for their past performance (e.g. through personal annual reviews) they tend to reduce risk taking if the client can review the performance and identify underperforming managers or complain to them. Notably, risk taking by fund managers is largely the same whether they operate under a flat fee or have an aligned incentive scheme where they invest their own money alongside clients’ money. This is essentially a reflection that fund managers are human and humans are social beings who crave the acceptance and approval of their fellow beings. And the more fund managers meet their clients, the more they get that approval (or not, if they lose money). This feedback from clients through personal approval seems to be as strong a force as investing personal wealth in their fund.

Where things really go wrong is once convex incentive structure come into play. When the fund manager shares in the upside but not in the downside, there is a strong incentive to take more risk and indeed, compared to a flat fee, fund managers operating under a convex fee structure take on substantially more risk. In one experiment, fund managers received a 5% performance fee on all the profits their clients had but faced no penalties if their clients lost money. The reaction of fund managers compared to a flat fee was to double their investments in risky assets.

And in lab experiments you can do what you can’t do in real life. So in a follow up experiment, the fund managers were rewarded with a bonus of 50% of their clients’ money if they made a profit. This created a negative expected return for their clients if the fund managers invested in risky assets, but guess what, the fund managers didn’t care. They invested the same amount in risky assets as under a convex fee structure even though they knew their clients would lose money.

There is a reason why I stay away from money managers who charge 2 plus 20 or similar convex fees.