In a previous post, I ran through the manifold challenges that asset managers are likely to face in the years ahead and argued that non-incumbent managers should adopt performance-based fees.

Now, that'll probably sound like hari kari to the average fund manager. Why hop off the gravy train, they might argue, when it's merely slowing, not screeching to a halt? Here are a few reasons:

Apart from eating one's own cooking, there is no better way to align a firm with the success of a given investment strategy.

If the firm's profitability rides on adding alpha, as opposed to simply gathering assets or coasting on a market tailwind, then you better believe the fee structure is going to have a catalyzing effect on firm culture. Getting the job done for the investor is literally job one.

It promotes good research and product development.

When adding value is the cornerstone of a firm's very existence, rigorous research is going to be placed front and center, where it belongs. Further, the investment approach will coalesce around what makes sense, rather than what's likely to resonate loudly in the market. How so? Let us count the ways: regarding stocks as ownership in a business, not pieces of paper; focusing on the long-term, over which economic value is created or destroyed, rather than anchoring on the short-term based on what one thinks the market will pay; retreating from, not chasing, the latest trend. These are the hallmarks of disciplined product development, which a performance-based incentive system promotes, for anything short of that will burn a hole in the firm's pocket.

There's a collateral benefit as well: Management fees are likely to decline. Why? Retail management fees are routinely marked-up on the assumption that for every product that's a hit, there will be two or three others that fail to gain traction. In effect, more-successful products subsidize less-successful ones. The less-disciplined product development, the lower the ‘hit' ratio, the more pressing the need to build a buffer into the management fee. This ends up inflating management fees across the board.

But with more disciplined product development, there's less need for that buffer. Thus, management fees should gradually trend down.

The fee structure removes disincentives to close strategies before capacity gets out of hand.

As it stands, a manager who pulls down a fixed management fee isn't going to be chomping at the bit to close a strategy given that it will throttle growth. (Firms like Wasatch and Bridgeway, which routinely close funds well before asset bloat sets-in, are a rarity.) By contrast, the manager who employs a fee structure like the one I'm describing has a huge incentive to close a strategy in a thoughtful, timely manner-it ensures that the strategy continues to add value, which is the manager's paramount concern.

Yeah, lock-ups give hedge fund and private equity managers the luxury of closing a strategy at a given level-after all, those assets aren't going anywhere. But it's more fundamental than that - closing the strategy preserves its effectiveness, or at least lowers the odds that performance will revert to the mean as assets flood in, thereby limiting the manager's opportunity set.

It's cheaper to the client.

Say what? That's right - it's cheaper to the client. Here's why: The use of a traditional, flat basis-points-on-assets fee structure discourages, rather than promotes, judicious risk-taking. It's a business model that stresses asset growth, not performance for performance-sake. Thus, managers take what, in the grand scheme of things, are pretty modest bets in hopes of riding the market tailwind and then inching past peers and, maybe, the benchmark after fees and transaction costs are factored in. The upshot is that returns generally vary within a pretty tight range about the benchmark.

(Incidentally, I'd also argue that this volume-driven business model has been the seedbed for other counterproductive ‘innovations', such as the 12b-1 fee...the business imperative for which becomes much less compelling once you start rethinking the fee structure...you don't necessarily need to incent an army of brokers to push your product if the performance fee does most of the heavy lifting. Yeah, you better add value for the client over the long haul, or else. But isn't that why you're in this business in the first place?)

The trouble, as it were, with this approach is that it has tended not to work. And when it doesn't work-i.e., when the fund has hovered near or skirted its benchmark index's returns-it's a bum deal for the shareholder. For instance, the fund matches the benchmark pre-fee. The manager gets his take-say, a 50 basis point management fee-and you or I get squat (actually, we get 0.50% worth of underperformance...gee, thanks). Or suppose the fund lags the benchmark by a percentage point. Again, we incur every last basis point of pre-fee underperformance and yet the manager still gets his taste, deepening the shortfall.

Now contrast that with a performance-based fee. Suppose that the fund levies a 0.20% base management fee and a performance adjustment equal to 50% of any outperformance/ underperformance versus the benchmark outside of a specified corridor, say 1.5%. (More on this structure in a bit) If the fund matches the benchmark, then the manager gets its 0.20% but no performance adjustment, putting him in the same boat as you or I, the lowly shareholder.

Then let's suppose the fund lags the benchmark by three percentage points. In that case, the manager will have to cough up 0.55% and pay it to the fund (0.20% base management fee less a 75 basis point performance adjustment equal to 50% of the 150 basis point underperformance outside of the corridor). In that case, the manager is actually feeling some of the shareholder's pain-he shoulders 55 basis points of the 300 basis point underperformance.

Now, one can argue that this begins to break down when we're talking about significant outperformance under a traditional fee structure. In such cases, a flat percentage fee lets you or I keep the lion's share of those excess returns. The manager levying a flat 50 basis point fee in such a scenario is getting just that - 50 basis points. But with the performance-based fee structure, the manager is going to share in the good times, leaving investors with less of the spoils.

But the point is that funds, by and large, rarely deliver these types of returns. And I'd argue that that failure is at least partly attributable to the traditional fee structure, which discourages the kind of judicious risk-taking that's needed to garner such outperformance in the first place.

So, to borrow from Warren Buffett, it seems far preferable to adopt a system that enhances the investor's odds of gaining a lesser share of something (or, for you pessimists, of losing a lesser share of something) than inheriting a larger share of nothing or, worse yet, a deficit.

It forces fund companies to reckon with the way they define "management" fee.

One of the great misconceptions is that a fund's management fee pays solely for the portfolio managers, analysts, and research resources that are behind a given portfolio. Not so. It pays for a lot more than that-namely, "SG&A".

SG&A is always most significant in a fund manager's retail channel, where you've got to pay for wholesalers and phone reps and maybe make hard-dollar payments to wirehouses, etc. The reason SG&A is more significant in the fund world? The customer base is much more diffuse in dollar terms. Contrast that with the institutional channel, where managers can reach well-heeled prospects without having to haul around a large selling apparatus.

Ever wonder why fund managers charge a lower management fee to run an identical strategy for an institutional client (in a separately managed account), or as part of a subadvisory mandate? The dirty little secret is that they don't have to pad the management fee to cover SG&A, as they either aren't incurring those types of expenses (as with a separately managed institutional account) or another manager is bearing the costs (as with a subadvisory mandate).

What does that have to do with performance-based fees? Managers have a clear incentive not to pad their management fee, as a higher management fee represents a higher hurdle that the fund has to clear before reaping any performance adjustment.  Also, as previously mentioned, because a business model tied to investment performance isn't dependent on volume-i.e., keeping the sales engine humming to drive asset growth-then SG&A becomes a less significant part of a manager's cost structure.

Also, it forces the manager to think more carefully (honestly?) about the economics of running money. When I used to cover asset managers, my glib response to the question ‘just how scalable is this business?' was ‘as scalable as managers want it to be'. (For those seeking an example, writ large, of the business's profit potential, check out the financials for quantitative manager LSV Asset Management, which is a unit of SEI Investments. Helllloooo 90%-plus operating margins.) That is, in an intellectual capital-centric business like asset management, you know compensation is going to be the biggest cost, bonus in particular. But there's no immutable law that holds a manager must pay out x% of each incremental fee dollar in comp just...because. A performance-fee structure imposes a form of discipline in the sense that managers must be more mindful of the management fee they're charging.

Again, the management fee is a mixed blessing. Yes, it's a comparatively stable revenue source. But it also stands as a hurdle between the manager and the most lucrative portion of the revenue stream-the performance fee adjustment. Thus, the higher the management fee, the higher that hurdle. In that sense, it forces managers to think more honestly about the economics of the management fee-how much operating leverage is in the business, does the fee's size jibe with that, and does it terrace down appropriately as assets grow.

Here's where I'll sound like a fund industry shill: Performance-based fees would help to differentiate funds from other investment products.

You're sending a powerful message to investors when your fee structure essentially says ‘we're in the same boat'. It reinforces an important (and inescapable) facet of the industry's identity-active management--and underscores its mission-to add value.

Also, it most certainly would help to combat the growing perception that active managers are grossly overpaid for their services by dint of their high correlation to the broader market (exposure that investors could get through a low-cost index mutual fund or ETF).

And, finally, it would foster a healthy dialogue about the true cost of outperformance, especially when compared to the typical hedge fund manager's fee. That comparison is likely to reflect well on the fund industry (i.e., the low base fee, the relatively modest performance adjustment, the symmetry of the adjustment, etc.).