Performance-Based Fees and Moral Hazard: Aligning the Interests of Investors and Managers

Abstract

In an ideal world, the financial interests of asset managers would be perfectly aligned with those of their investors via optimal incentive contracts. In the real world, this is often not the case. It is worthwhile investigating how to improve the current situation. In the theory of delegated management the optimal incentive fee is often linear, under stringent assumptions. In practice we see that a lot of the incentive contracts are convex rather than linear, with option characteristics. This typically introduces moral hazard on the side of the manager. This article examines a number of fee contracts in practice. We propose several improvements on the standard convex fee contracts to better align them with the interests of investors. The key is to make actual fee arrangements more linear.

Keywords: Alignment, Delegated Management, Moral Hazard, Pension Fund, Performance Fee, Principal-Agent