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A performance fee fight

Welcome to The Rec List, a weekly compilation of the best research notes, academic papers, articles and posts aimed at anyone who works in manager selection.

A performance fee fight

Incensed by incentives

It has not been a great few days for performance-fee funds. One high-profile series of such funds in the US has been hit by a lawsuit over losses of $774m.

The lawsuit has been brought by the Arkansas Teacher Retirement System (ATRS) against AllianzGI over huge losses suffered by three funds it was invested in: the Structured Alpha US Equity 250, Structured Alpha Global Equity 350 and Structured Alpha Global Equity 500 funds.

These funds aim to replicate the performance of certain equity indices plus a given percentage of outperformance delivered by an options strategy. This is both long and short volatility and so aims to offer some downside protection in the event of a major sell-off, like the one in February and March.

Only, the protection never kicked in in February leaving the fund down more than the market. And according to the ATRS case, in an effort to recoup these losses the funds’ managers took additional risks in March. This was a deviation from their mandated investment strategy, particularly in terms of risk management.

Now, there are two important things to note at this stage. The first is that Allianz refutes the allegations and says it will ‘vigorously’ defend itself. The other is that our focus here is not going to be on the thrust of the case (i.e. how the strategy went wrong - you can read that about here and here) but instead on the allegation that the performance-fee structure of the funds was a motivating factor in the managers’ March response to the February losses. Per the Wall Street Journal:

Allianz’s desperation, the pension plan wrote, was in part driven by a fee structure that rewarded the manager only if the funds exceeded their benchmarks.‘The funds’ fee structure would have made it impossible for Allianz to earn any fees for its management of the funds for the foreseeable future if the losses experienced in February were not recovered by the end of March,’ the suit wrote. ‘Faced with these realities and motivated by self-interest, defendants risked client assets to recover these short-term losses.

This allegation will not come as a huge surprise to many analysts, who raised such concerns in February last year, following a flurry of launches of performance-fee funds. As one such analyst, HighMark Capital Management’s James St. Aubin, told Citywire at the time:

‘If you have an underperforming manager that wasn’t earning a fee, they may be incentivized to take more risk, simply to give them an opportunity to earn higher fees.’

Equally, AssetMark’s Zoe Brunson noted:

‘Yes, it gives managers more skin in the game because they will only get paid when they produce a positive return, but what does that mean for a strategy that could be out of favour? Are they then suddenly going to change their investment style so that they receive fees?’

Now, of course, the presence of a performance fee is no way of telling that a volatility fund would double down on its short positions one week into a major sell-off in the hope that things calmed down, but the suit highlights the importance of incentive structures (among many other things) in fund due diligence.

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