Clients and managers have so far taken a somewhat cavalier attitude toward the specifics of performance-based fee (PBF) construction. Consider, for example, a PBF arrangement in common use today—the one-year symmetrical fulcrum fee. Under this arrangement, the manager shares a constant proportion of the excess earnings above or below a specified target portfolio return. The arrangement has the virtue of simplicity, but if not well defined, it can work against the best long-run interests of the client.

To begin with, the target portfolio must be correctly and explicitly defined; the manager’s performance must be measured against a benchmark that properly reflects his investment style. Furthermore, the fee caps common to most of these arrangements must be set with care. Too low a minimum or a maximum fee merely provides the manager with an incentive to “play it safe,” in the interests of either locking in a maximum fee or avoiding a minimum fee that does not cover the fixed costs of doing business. In either case, the client may end up paying active fees for passive results. Finally, the period over which the manager’s performance is evaluated should be long enough that his true skill is not obscured by short-run variability; one year is likely too short, while five years may not be too long.

Although most performance-based fee calculations are based on rates of return, a superior alternative would be to base calculations on the same units in which the client’s goals are defined—namely, dollars. A dollar-metric PBF arrangement rests on the difference between the manager’s portfolio and a benchmark-equivalent account (BEA). Both start off with the same investment; over time, the manager’s account will change on the basis of its investment performance, while the BEA will change on the basis of the performance of the manager’s benchmark. The divergence between the two represents the value added by the manager and forms the basis for calculating the manager’s compensation.