Long-Run Investment Management Fee Incentives and Discriminating Between Talented and Untalented Managers

Robert Ferguson and Dean Leistikow

Volume 1, Number 4, Fourth Quarter 2003

Ferguson and Leistikow [(1997). Journal of Financial Engineering 6, 1-13] (FLa) was the first long-run risk-neutral analysis of the performance volatility incentives created by investment management fee structures. This paper extends FLa in six ways. It allows the portfolio’s value to change, incorporates expected investment performance, and addresses expenses and distributions. It also shows the impact of paying investment management performance fees from the portfolio, and determines if the contract renewal structure and fee arrangements discriminate effectively among talented and untalented managers. Finally, it introduces a volatility-dependent contract renewal structure that provides good discrimination and strongly motivates manager behavior consistent with client preferences.