Understanding Fee Structures in the Asset Management Business

This paper considers the economic role of fees in aligning the incentives of money managers with those of investors. We examine a simple model in which manager effort (or investment in human and physical capital) is observed by the investor prior to her investment decision, but is not verifiable. This setup creates a positive economic role for net asset value (NAV) as a contracting variable and thus provides an explanation for the widespread use of contracts based on NAV in both the mutual and hedge fund industries. We also provide an explanation for why hedge funds use asymmetric performance fees while mutual funds typically charge a fixed fraction of NAV (even though 'fulcrum' performance fees are available)