March 3, 2010
Kirill Ilinski
Fusion Asset Management Working Paper No. FAM-02-10
Abstract:
In this paper we introduce a novel structure for performance-based compensation, the Shock Absorber Fees (SAF). SAF includes three main structural elements: partial transfer of risk from investors to the manager through recourse to the manager’s fees; asymmetric nature of the recourse when manager is covering larger percentage of loss than he is receiving in gains; dynamical nature of the exposure when the amount of protected exposure is linked to the fees already accumulated. Due to the risk-transfer feature of the structure, investment products with the Shock Absorber Fees demonstrate dramatic improvement of statistical characteristics of returns, such as downside volatility, maximal drawdown and Sharpe Ratio, which makes the products more desirable for investors.
Managers too benefit from the structure by increasing stability of the investment base, effective mechanism of increasing assets under management in performing products through dynamical change in the exposure, and by ability to earn overall higher fees in performing strategies. Wide implementation of SAF-like structures will contribute to improving global financial stability by removing the conflict of interests between investors and managers, which is inherent in simple percentage performance fees, and will create an incentive for responsible money management. It is argued here that SAF would have considerable social and economic benefits by partial de-risking of investments, better protection of non-professional clients directly or indirectly involved in financial markets, wider participation in financial markets leading to higher rate of investment and global productivity growth. While the main SAF application considered here is chosen to be compensating investment managers for performing investment management services, the proposition is applicable to wide range of decision-making and resource-managing services.
Download Responsible Compensation Structure: Shock Absorber Fees.
