Investment Fee Calculator
What constitutes a fair fee? For many premium fee structures, a high historical Sharpe ratio and the concept of scarcity is the only determinant. However, this simplistic approach is not sufficient - there are multiple variables that need to be considered when establishing a fair fee.
The Impact of Risk Management
The concept of paying fees for investment management is grounded in the belief that an investment firm is more capable of managing money because of its privileged access to insights and markets. These advantages manifest in improved risk-adjusted returns, risk-adjusted being the operative term.
Measuring returns on a risk-adjusted basis is essential, especially when evaluating a fund with premium fee structures. In the hypothetical scenario below, you allocate $100 to two managers that both generate 25% annualized returns on average.
In the case of our hypothetical managers, even though both managers were able to produce the same returns, Manager B’s performance illustrates significantly lower volatility. In this sense, Manager B’s performance justifies higher fees in contrast to Manager A even though both were able to produce the same returns. We believe that fees are justifiable only if the returns produced are complementary to a portfolio and charged modestly enough so as not to diminish yield.
What to Assess
We’ve identified three core values that should be evaluated when assessing fees, as each component indicates the quality and subsequently higher fees associated with an investment manager.
|While there are many ways to measure risk-adjusted returns, we chose the Sharpe ratio because of its straightforwardness and ease when it comes to inter-strategy comparison.|
|When measuring how complementary a strategy is to your portfolio, correlation is the most important metric. If your portfolio is dominated by buy and hold equity exposure, correlation should be measured to an appropriate index. If your portfolio is a 70/30 traditional split, the index to which correlation is measured should similarly reflect this.|
|Put simply, the longer the manager has been around, the more reliable his or her results are.|
There are an infinite number of ways to create an alternative strategy on a spectrum of complexity. In the end, if the strategy cannot produce sustainably high risk-adjusted returns with low reliance on the exposure you already have within your portfolio, there is no rationalization for steep fees.
What to Pay
At the core, fee structures are made up of two distinct fees: the management fee and the incentive fee. Management fees are a percentage of AUM and typically a direct reduction paid regardless of performance. Incentive fees are a percentage of the returns, typically paid after alpha passes a specific threshold of performance.
In theory, a higher expected gross return makes a higher management fee less impactful as a percent of performance. Investors can mostly count on returns being a function of volatility for robust strategies - to count on greater than a 1.2 Sharpe Ratio out-of-sample for a liquid strategy is quite optimistic. Therefore, all else equal, an investor should be hesitant to pay more than 10% of expected annual volatility in management fees if they are also paying an incentive fee. If the management fee is paid in lieu of an incentive fee, the investor should pay half or less of the expected incentive fee in management fee.
A strategy can add value to your portfolio while simultaneously not being deserving of a management fee, such as a strategy with intermittent signals and low volatility. However, if it has negative correlation to your underlying portfolio, perhaps it is worthy of a higher incentive fee.
In general, an investor should be skeptical of a manager’s ability to sustain high Sharpe Ratios along with an ability to produce returns negatively correlated to traditional indices. To pay high management fees for these strategies is a mistake, but paying a higher incentive fee makes sense. Paying both high management fees and incentive fees, however, simply gives the manager too much of your returns.
The Fair Fee Framework
To calculate a fair fee, we measure factors related to the strategy, manager, and allocation size in order to generate a fair fee assessment based on the real sources of value produced. After entering the fund’s Sharpe ratio, correlation (to S&P 500), track record, and volatility along with the desired investment amount, our fee tool adds or reduces management and incentive fees based on user input.
Along with calculating a fair fee, the tool enables users to input their own managers’ fees to see how they compare to our recommended model, the 2-and-20, and the 1-or-30. Our goal is not to declare the exact fees that managers should charge, but rather to educate investors more generally on how to think about fees as they make their liquid alternative investment decisions.