Some time ago, I had a discussion with a colleague on the alignment of interest in hedge funds. Understandably, the discussion focused on the design of fee structures, and on performance fees in particular. For any decent investment size, fees are normally negotiable, and it is up to the investor and fund manager to agree upon a fair level. The final deal is dependent on the negotiating power of the two parties and the particular circumstances of the investment (such as seeding, size, lock-up, capacity, and so on).

Having agreed that the fee levels are a question for negotiation, we discussed whether there were any possible flaws in the overall design of the fee model. Are there situations where the manager could game the fee design, thereby possibly misaligning the interests of the investor and the fund manager?

The answer is yes. Opportunities for misalignment exist, but there are relatively easy remedies.

For many hedge funds, at least smaller ones, the fixed fees are needed to cover running costs of operations. The true upside potential comes from performance fees, so receiving these fees regularly enough is desirable. Here lies the root of a possible issue. 

“The randomised model could be useful, as it helps to identify potential loopholes in the standard model. And if anything needs a thought experiment, it is fees.”

Imagine the following situation: The manager has had a very good start to a quarter and the quarter-end is approaching. The performance fee will be crystallised at the quarter-end, but there are still two weeks to go. Is it not conceivable that the manager feels tempted to start playing it safe in order to guard the performance fee? The manager might reduce the risk of the positions or even get out of some of the riskier positions, not because he needs to do that from an investment risk/return perspective, but because he is optimising his fees. However, assuming that the opportunity set is unchanged, he should probably maintain his original positions. Failing to do so will reduce the long-term return of his portfolio, contrary to his clients’ interests.

Whether imaginary or not, there are easy ways to resolve the quarter-end problem. One idea is to randomise the day on which the performance fee is calculated. A simple method is, after the end of the quarter, to randomly select a month-end within the quarter in a controlled fashion. The performance fee—and high-water mark (HWM)—is based on the net asset value (NAV) at that month-end. So if we are in the second quarter and April is drawn, the performance fee and HWM would be based on the April reading. Neither the manager nor the investor controls the random number generation; the number is drawn by a third party—for example, the fund administrator. The possible performance fee would still be paid after the quarter-end, as before, the only difference being that the fee is calculated based on the performance at the randomly determined month-end. Alternatively, one could randomise even further by drawing a random day within the quarter, but with the need to strike intra-month NAVs, this might get over-complicated.

Over time, the random method would not change the overall performance fee earned/paid, so neither the manager nor the investor would be favoured or penalised. Admittedly, there is the added complication and cost caused by administering the random number-draw. The method might also lead to occasional unintuitive fee payments; for example, a performance fee might be earned (because of good intra-quarter results) during a negative quarter or vice versa. But as the role of the quarter-end as the measurement day has been abolished, the temptation for playing safe is reduced.

Nothing is completely straightforward. Firstly, some incentives to game the quarterly figures remain despite randomising. A manager still wants to achieve a good quarterly ranking in the various hedge fund databases. Even some investors might prefer the manager playing it safe, because of quarterly performance reporting and their own career risk.

Secondly, there are situations where reducing risk around certain dates is based on a truly changed opportunity set or an altered risk/return trade-off. Examples include the release of important economic data, uncertainty around elections, and year-end US congressional decisions on debt ceilings.

Thirdly, there might be simpler ways to avoid the possible conflict of interests. A natural solution would be to increase the transparency given for clients. For managed accounts, the transparency is already there.

Still, as a thought experiment, the randomised model could be useful, as it helps to identify some of the potential loopholes in the standard model. And if anything needs a thought experiment, it is fees.

—Erik Valtonen is CEO of Blue Diamond Asset Management, a hedge fund based in Pfäffikon, Switzerland. He was formerly the CIO of Swedish pension buffer fund AP3.