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April 03, 2007 Chasing Alpha
The asset management industry is currently in the midst of a paradigm shift. In early March of this year, I discussed the benefits of performance fee refunds to compensate investors for sub par returns. However, while many investors and asset managers laud the alignment of interests (of investors and asset manager) through charging for alpha, as opposed to beta, criticisms have inevitably come to the forefront.
For example, Fidelity recently received "a chilly response" to announced plans to subject 19 Fidelity Advisor Funds to performance fees. While Fidelity and others tout the benefits of the switch to performance fees, other investment managers perceived increased risk.
Given the nature of performance fees, it makes sense that since investors are really seeking alpha (returns in excess of the market), and mangers of performance driven funds only get paid for alpha, that interests are aligned. However, many wealth managers are avoiding performance fee based funds. The perception is that alpha driven asset managers are being encouraged to undertake exceedingly high-risk investment strategies.
Consider this, if an asset manager is chasing alpha too aggressively, the potential for large losses increases. The prospect for large losses for many risk-averse investors mitigates beneficial fees structures. Both the promise of fee elimination or even fee refunds wouldn't provide consolation for an investor whose account value has dropped 30, 40, or even 50 percent.
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