The value of a typical incentive fee—one that does not penalize the manager for underperformance—may be calculated by treating the fee as if the manager had a call option on some fraction of the portfolio’s incremental return. The value of this call increases as (1) the spread between the standard deviations of the portfolio and the performance measurement benchmark widens; (2) the correlation between the two declines; (3) the value of assets under management increases; (4) the manager’s percentage participation in incremental return increases; and (5) the performance measurement period lengthens.
The manager’s control over portfolio risk, hence over factors (1) and (2), poses a certain moral hazard. The manager may be tempted to manipulate the portfolio’s risk, not in order to satisfy the client’s risk requirements, but in order to increase his own chances of receiving a high fee. Close monitoring of portfolio risk by the client can do much to alleviate this hazard.
Another inherent problem with incentive fees—distinguishing between returns that are due to the manager’s skill in actively managing the portfolio and those due merely to his investment style—can be dealt with by choosing the most appropriate benchmark portfolio. However, there is a third problem that defies both manager and client control—distinguishing between skill and chance. Investment returns are primarily random over short time periods. Lengthening the performance measurement period can help to separate skill from chance; in some cases, however, incentive fees are likely to end up rewarding a poor but lucky manager while penalizing a skillful but unlucky one.
