LOS 27.u Ad Valorem Fees

CFA Level III Equities
#1

I really doubt this is a critical issue, but I am curious about this statement in the Schweser text on p 171 of book 3.

“Their [ad volrem fees] disadvantage is that they do not align the interest of managers and investors the way performance-based fees do.”

I don’t understand why this is true. I mean, the way ad valorem fees work… a manager collects higher fees after portfolio appreciation, and is also deterred from taking on too much risk because they don’t want the possibility of large portfolio depreciation. It seems pretty consistent with the most investors objectives to me. That is, they are likely to make rational risk-return decisions that would be conssitent with investors objectives. In what way could the managers and investors interest not be aligned?

Thanks!

#2

On the other hand, the Schweser text goes on to say:

“The advantage of performance-based fees is that they align the interests of the manager and the investor, especially if they are symmetric (i.e., contain penalties for poor performance and rewards for good perfomance).” Isn’t this exactly what an ad valorem fee structure accomplishes?

#3

Hi Clark,

Performance fee & AUM Fee or Ad Valorem fee are two ways the manager earns money…

Ad Valorem fees are AUM fees… Meaning fee calculated based on the Asset being managed, nothing to do with performance here.

So the curriculum is trying to say that the manager might increase his AUM, to obviously collect more fee, even though this might not be for the good of the investors…

This is different from the performance fee you are talking about. Hope this helps.

#4

But there are two ways to increase AUM: solicit more investors, AND/OR with positive portfolio returns.

Performance Based Fees: Good performance -> collect more fees AUM Based Fees: Good performance -> Increases the value of your AUM -> collect more fees

#5

Hmm, I do agree…

But this talks generally about the trend with managers to chase the easier way - which is to add more AUM…

#6

Performance-based fees: a 2% return gives the manager twice the fee as a 1% return: a 100% increase in fees.

Ad valorem fees: a 2% return gives the manager a 1% increase in fees over a 1% return.

Performance-based fees: 2% loss gives the manager no fee (or a negative fee).

Ad valorem fees: a 2% loss gives the manager 98% of the zero-return fees.

1 Like
#7

“Their [ad volrem fees] disadvantage is that they do not align the interest of managers and investors the way performance-based fees do.”

The alignment of interests is that both parties want to make money.

Under an AUM fee arangement, a FM can potentially sit on their hands and take a fee while the investor loses x% of their capital. Therefore a win for FM but a loss for investors.

Alternatively, with Perf. Fees, the FM gets paid if they make money (in which case the investor also gains from the profit). Therefore a win for both parties i.e. interests are aligned.

This is not so much a question about long term ideals but what makes money for both parties this year.