With a recent paper, four researchers from Hebrew University in Israel are challenging the assertion of many regulators around the world that performance-based fees encourage dangerous risk-taking.
The crux of the researchers’ argument is that high levels of investment in alternative assets like private equity – seen by many observers as posing liquidity risk and providing insufficient risk premiums – aren’t as risky as commonly believed when taking into account other measures of risk, like return volatility.
It’s an interesting thesis, although it does fly in the face of other research.
From the paper:
While most regulators worldwide take the view that profit-based fees are risky and should be prohibited in pension fund management, our results cast doubt on the validity of this view: funds with performance-based fees are associated with more risk-taking in comparison with AUM-based funds only if risk is measured in terms of investment in illiquid and presumably risky “alternative assets.”
Comparisons based on other measures of risk, such as return volatility, are not highly consistent with the regulatory view. By contrast, funds with performance-based fees are clearly associated with high-quality investment management. Stated differently, even if funds with performance-based fees can be regarded as riskier than other funds, there seems to be a tradeoff whereby this higher risk is accompanied also by better investment management. We also find, within the limitations of our sample, that incentives (profit based fees) seem to be more effective than competition in inducing in inducing high-quality fund management; competition however, leads to lower fees for investors.
The researchers also recommended a revamp of current regulatory policies to better manage risk-taking by fund managers, as well as relax the restrictions on performance-based fees. Instead, they can turn to other measures including imposing fiduciary limits on specific types of risky investments. They, however, clarify that these recommendations should be adopted only as they apply.