132 - Is it better to pay management fees or performance fees?

Mental Models discussed in this podcast:

• Incentives
• Skin-in-the-Game
• Accredited vs non-Accredited Investors

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Show Outline

Key Concepts for thinking about compensating a Portfolio Manager

• Management Fees 
  • Management Fees are priced a percentage of the assets under management. 
  • A 1% management fee means that you will pay 1% of your assets being managed to the investment manager regardless of the returns you receive on your investment. 
  • If you have $100k invested at the beginning of the year, you'll pay $1k in fees, if your investment doubles, and $1k in fees if your investment gets cut in half. (ignoring the weighted average effect)
  • Management fees can be charged to both accredited and non-accredited investors
• Performance Fees 
  • Performance fees are priced as a percentage of the profit earned on investments over the course of a year. 
  • For instance: A 10% performance fee would provide the manager with 10% of the total profits earned during the year. If you invested $100k, and the $100k grew to $200k, then the investment manager would earn $10k. (10% of the 100k gain). 
  • However, if the investment fell to $50k, the investment manager would earn nothing. 
  • Performance fees can be charged only to accredited investors.
• Hurdle Rates 
  • Hurdle rates are often paired with performance fees to ensure that investment managers only earn performance fees above a certain level of return. 
  • For instance: A hurdle rate of 5% would mean that the profit sharing only kicks in after 5% returns have been earned for the year. In our prior example, if you invested $100k that doubled to $200k, then the "profit pool" is instead $95k, because the first $5k is exempt. The investment manager then only earns $9.5k.
• High Water Marks 
  • High water marking is where hurdle rates are compounded across multiple years. 
  • In this case, let's assume you invest $100k, and the hurdle rate is 5% per year. 
  • In year 1: your investment declines to $80k. You pay no performance fees. 
  • In year 2: Your investment grows to $110k. You still pay no performance fees because despite earning 37.5% rate of return in year 2, the hurdle rate of 5% compounded in each year, so the investment manager only starts to earn fees after 10% (5% + 5%) on the original $100k. So they would only earn returns above $110k in year 2. 
  • In year 3: They only earn performance fee returns above $115k (ignoring compound growth here).
• The Buffett Model 
  • 0 % management fee,