I don't think performance fees help. Actually, I suspect performance fees probably do more harm than good.

Reason 1: Work smarter not harder

First, it is tough to incentivise people to be smarter. Numerous studies have shown that while bonuses make people work harder at simple tasks, they don't make people smarter. Some even argue it makes people worse at cognitive tasks.

I'm already giving my investors the best portfolio I can. Offering me a performance fee isn't going to change that.

And, if you expect by paying a performance fee that your investment manager will give you the "real" portfolio rather than the trash they give everyone else then you have the wrong manager.

Reason 2: Performance fees aren't a core part of an investment process

Performance fees are not guaranteed. If I had a performance fee, I wouldn't set up my superannuation/investment management business to rely on performance fees coming in every month to pay for regular costs.

i.e. I would take the base fee you are paying me and use that to hire the staff, buy the research and data, perform the analysis. Everything that I need to do to run the fund and deliver the performance.

Then when I got a performance fee, I would use that to buy a yacht, a sports car, corrupt democracy etc. Just the usual stuff fund managers do with money they don't need.

Reason 3: Performance fees dial up the risk

Once I have an investor, it is usually difficult to lose them. Sure, there is "hot money" that continually jumps from one winner to another - but they are the exception rather than the rule.

Most investors give an investment manager money and then only move it when the manager stuffs up. And usually, it needs to be a decent-sized stuff up.

So the incentive for the manager is to try and beat the market but avoid big stuff ups - a nice alignment of interest for most investors.

However, with a performance fee, now I have a different incentive.

I can get huge fees by running higher risks with your money. What is the worst that can happen? You leave, which was always a risk anyway.

So, my incentives change. Rather than go for safer returns, the temptation is to dial up the risk and chase big wins. Maybe that means a little more leverage. Perhaps that means I get caught chasing growth stocks at the wrong point of the cycle.

The net effect is I would make more by having one massive outperformance year and four bad ones than I would five above average years. Most investors prefer the opposite.

Reason 4: Perverse incentives

Most performance fees only get paid when performance has increased the value of a portfolio.

I'm going to use an extreme example. Over March so far, our tactical growth fund is down less than 1% vs stock markets down 30%. Even accounting for most superannuation funds having some defensive and unlisted assets, we estimate we have outperformed funds with a similar strategic allocation by around 20%.

If we were charging (say) a 20% outperformance fee, then that would be a hypothetical performance fee of around 4% of every dollar invested. In one month. In context, we actually charged 0.05% for the month (0.64%p.a.).

So, with a performance fee, we would have made 75x our usual monthly fee. I probably wouldn't get 75x my usual monthly fee paid straight away (most performance fees have conditions), but my fund would be "pregnant" with performance fees that I would earn as markets recover.

This would give me a perverse incentive. I could either:

1. Keep managing the money normally, trying to do the best for clients. The risk for me is I get it wrong and lose some of my performance fee.
2. Simply "shut up shop", match my portfolio to the benchmark so that I get the average performance. i.e. I spend a year or two harvesting my usual management fee PLUS all of the performance fees without risk.

You tell me which one you would do.

Final Take

The real reward for investment performance is that investors give me more money to manage and tell their friends who also give me more money to manage.

That should be enough of an incentive for your investment manager to try to outperform.

You can pay your investment manager performance fees if you like. But don't expect it to make any difference to investment performance.