Performance-Based Fees and Risk Shifting with the Knockout Barrier

Xiaodong Xu and Bernd Scherer

Volume 5, Number 3, Third Quarter 2007

Many investment firms reward portfolio managers based on their performance. This article investigates a manager’s optimal active risk policy using stochastic programming techniques. Our multiple-period model incorporates the most common incentive-fee structures, and captures the risk that the manager is fired for underperformance. In contrast to single-stage models, the manager shows remarkable prudence as he strives to safeguard future fee flows. We observe that if the client is too intolerant of underperformance, the manager will be incentivized to reduce active risk despite earning active fees.We also observe that capping fees too early will causes a lock-in effect.