Human self-interest plays a central role in behaviour and decision-making, none more so than in investing. As Charlie Munger, renowned investor and thinker, observed, “Show me the incentive, and I’ll show you the outcome.” Understanding how incentives shape decisions is crucial when investing. Munger, in his writings identified 25 human biases which can lead to errors of judgement, but number one on the list was the power of incentives, which he later upgraded to the “superpower of incentives”.
Studying and understanding where incentives lie is important when sifting through the many investment proposals being advanced by advisers and fund managers.
At Saxe Coburg, we pay particular attention to incentives when selecting funds – is there alignment between the interests of the fund manager and our interests as investors.
Most managers charge a flat fee based on the funds under management, regardless of performance. This incentivises growth in fund size, not necessarily better returns. As a rule, the larger a manager becomes, particularly in specialist capacity constrained strategies, the more difficult it becomes to deliver superior returns. It is important to understand these capacity constraints across different strategies.
Managers who are prepared to cap their size to protect performance will generally charge performance fees and this creates greater alignment with clients—only earning more by delivering results. We prefer such managers and often redeem from funds that grow too large and lose this alignment.
The other thing performance fees achieve, is a keener focus on ‘not losing money’. When a manager loses money, he earns no performance fee until the losses have been recovered. This would not work for an index fund, or a strategy which tracks very closely to an index as many actively managed funds do, because losses can stretch out for several years.
You could argue that performance fees incentivise a manager to go for broke and pile on the risk in the hope of one big payday. But when you consider the other ‘incentives’ at play, having their own capital invested (see below), the business risk of suffering an outsize loss, the impact to their income whilst losses are recovered, we think, on balance, performance fees better align the interests of the manager with the investor.
Skin in the game
We favour managers who invest their own money alongside ours. This demonstrates their confidence in the fund’s strategy and creates greater alignment between the manager and investors in the fund.
We have looked at many funds, pitched by experienced investors that have failed on this question, “how much of your own money are you putting into the fund?”
We also like it when the manager and staff can only invest in the fund, or the funds of the manager. This creates further alignment. It means their efforts are totally focused on the fund.
As funds mature and grow, incentives can shift. We regularly review whether managers’ priorities remain focused on performance rather than asset retention and adjust our allocations if interests diverge.
Incentives and credit
Investing in credit funds the incentives are different. There’s rarely upside—only downside risk. Success means receiving full repayment of principal and interest on time. A single bad loan can result in a permanent loss. That’s why incentives in credit should focus on capital preservation, not chasing returns.
This raises an important question: should credit funds charge performance fees?
Some argue hurdle rates (a minimum return the manager needs to achieve before performance fees kick in) are sufficient to ensure managers are rewarded for skill, not just for receiving the market return. But true skill often only reveals itself in hindsight, and few managers agree to claw-backs if their returns prove illusionary.
Another issue specific to credit funds: up-front arrangement or establishment fees. Should managers retain these or pass them through to the fund? Retaining them may prioritise volume over quality, rewarding more deals, not better ones. It also creates the opportunity to charge higher up-front fees and a lower interest rate. We prefer it when these opportunities don’t exist and when all revenue flows into the fund. As Charlie reminds us “never think about something else when you should be thinking about incentives”.
In investing, incentives matter. They shape behaviour, guide decision-making, and influence outcomes. As allocators of capital, we understand how incentives work, and how they evolve, which is key to protecting and growing our clients’ wealth over the long term.
If you’d like to discuss how we ensure your incentives remain at the heart of our approach, get in touch with Mark or Sam.