Practical Applications of On the Valuation of Performance Fees and Their Impact on Asset Managers’ Incentives

Abstract

In On the Valuation of Performance Fees and Their Impact on Managers’ Incentives, from the Summer 2021 issue of The Journal of Alternative Investments, Wei Dai and Savina Rizova, both at Dimensional Fund Advisors,and Robert C. Merton at the MIT Sloan School of Management, remind investors that performance fees can be valued using option pricing theory. Several researchers have applied an option-based approach to the valuation of hedge fund fees and other alternative investments’ performance fees, but few, if any, have done so for long-only systematic managers. The lack of research in that space is mostly because US legislation in the early 1970s banned mutual funds from charging asymmetric incentive fees. Recently, however, more managers of long-only, systematic, separately managed accounts are charging performance fees. The authors, therefore, focus on these types of accounts while illustrating how to use option pricing theory to value a wide variety of performance fee structures. Increased adoption of performance fees in long-only managed accounts coincides with investors’ increased interest in long-only systematic strategies.