Portfolio Management Fees: Assets or Profits Based Compensation?

This paper compares assets-based portfolio management fees to profits-based fees. Whilst both forms of compensation can provide appropriate risk incentives, fund managers ́ limited liability induces more excess risk-taking under a profits-based fee contract. On the other hand, an assets-based fee is more costly to investors. In Spain, where the law explicitly permits both forms of retribution, assets-based fees are observed far more frequently. Under this type of compensation, the paper provides some insights into how management fees should be determined in order to solve the principal ́s trade-off between providing better risk incentives and incurring a lower cost of compensation.