Carrot and Stick: A Risk-Sharing Rationale for Fulcrum Fees in Active Fund Management

Abstract

We show that risk-sharing considerations rationalize symmetric benchmark-adjusted (''fulcrum'') fees in the compensation of privately informed active fund management. By tying fees symmetrically to the appropriate benchmark, investors can tilt a fund portfolio toward their optimal risk exposure and realize almost the full value of the manager's information. Since fulcrum fees do not alter the manager's preferred payoff profile, the optimal contract saves the cost of compensating the managers for exposure to undesired risk and attains near-first-best risk sharing. Under certain conditions, fulcrum fees are not only optimal but necessary to avoid a dominance of active management by passive alternatives.

Keywords: Portfolio delegation, benchmarking, fulcrum fees, asymmetric information, passive management

JEL Classification: D82, G11, G23