Remember the tale of the cobra
Investors need to check the motives for fund managers.
You get what you incentivise. If a business incentivises sales by payment commissions, it may get higher sales, but possibly not profitable ones.
If a board incentivises the chief executive for a high share price with payment via share options, it may get a high share price, but possibly not a better company. If investors incentivise a fund manager to get greater returns by way of performance fees, they may get better returns, but possibly with greater risk.
The business and financial world is full of examples of incentives gone wrong with negative, unintended consequences. Perhaps the most commonly repeated example comes out of India in the 19th century. This story may be apocryphal but it is said the ruling British decided that Delhi had too many venomous snakes. To reduce snake numbers and make the city safer, the British decided to pay a bounty on every dead cobra that was brought in. This was greeted with delight by the Indians who quickly started to breed and farm cobras and brought them in for payment in great numbers.
Inevitably, some of the farmed snakes escaped, with the end result being a much higher snake population in Delhi.
Incentives need to be used sparingly and only after a good deal of thought. Sometimes, ideas for incentives glibly roll off the tongue and, if not well examined, can seem like an excellent idea. One example is performance fees that reward fund managers for achieving returns above an agreed level. These fund managers usually justify such a fee by saying they are aligning their interests with the interests of investors. This rolls off the tongue fairly smoothly and sounds reasonable – until you start to examine it.
Investors do want higher returns, but only at a given level of risk. The easiest way for a manager to get higher returns is to take on further risk, but they are not taking chances on their own money.
Fund managers on a performance fee may play the system. If they are a little under the bonus level, they may take on more risk. On the other hand, if they are already over the bonus threshold, they may turn off risk and lock in their performance instead of letting their profits run for the benefit of investors.
Quite clearly, a performance fee does not necessarily align the fund managers’ interests with those of the investors. The managers play the game with other people’s money and are not subject to negative performance fees (they do not have to pay back when they underperform).
Talk of performance fees and alignment is like assuming that dead snakes mean fewer snakes on the street. The British should have simply paid a salary to people who would go out and kill cobras just as fund managers should be paid a fair fee. This fee should be incentive enough to do a good job. And if you really want to know if the fund managers’ interests are aligned with the fund, ask if they have invested their own money.