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 Please review and rate the podcast If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience.  Follow me on Twitter and YouTube Twitter Handle: @TreyHenninger YouTube Channel: DIY Investing 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, 6% hurdle rate (w/high water marks), 25% performance fee  I think this is an attractive setup and I'd prefer to structure any future fund of mine with a similar arrangement.  This is the best alignment of incentives in my view. You don't get paid for AUM growth (directly), and only get paid for performance that beats a certain hurdle rate.  However, to do so excludes non-accredited investors. Therefore, if I want to serve non-accredited investors I'd have to charge a management fee at least for them. What is the right answer then? Non-accredited: You only have management fees. You obviously want a manager willing to charge them, or you don't get that manager at all. Accredited: Performance Fees may be your instinctual first option. They tend to align your interests with management. However, there are also downsides for you. May encourage managers to take more risk. Unless they beat a hurdle, they don't earn anything. They'll never be 100% aligned with you.  Without a management fee, you are limiting yourself to investment managers who are already financially independent and can afford to have years without income. Personally: I would be willing to pay or charge both sets of fees. My ideal setup is the Buffet arrangement: 0, 6, 25%. However, this isn't ideal for all investors. I could see the benefit of a 0, 10, 50% setup. I can see the benefit of only charging management fees (especially for retired investors who are seeking wealth preservation, not growth) As always: The answer is it depends. But, I hope that I have given you the information you need to understand how it applies for you. Summary: As an investor, you want to properly align your interests with your portfolio manager. A key consideration is how to compensate and incentivize that manager with either management fees, performance fees, or both.