Investment manager contracts outline the terms for managing investments, with a particular focus on liquidity provisions and fee structures. These elements significantly influence the suitability of a contract for the investor’s needs.
Liquidity
Pooled Investment Vehicles
- Closed-End Funds & ETFs:
- Liquidity: Traded intra-day on exchanges, offering the highest liquidity.
- Advantages: Investors can buy and sell shares throughout the trading day at market prices.
- Open-End Funds:
- Liquidity: Transactions are based on end-of-day NAV.
- Advantages: High liquidity but limited to daily redemption.
- Limited Partnership Structures (e.g., hedge funds, private equity, venture capital):
- Liquidity Terms:
- Redemption Frequency: Specifies how often withdrawals are allowed (e.g., monthly, quarterly).
- Notification Period: Time required to notify the manager before redemption.
- Lockup Period: Time after the initial investment during which redemptions are restricted.
- Hard Lock: No redemptions allowed.
- Soft Lock: Redemptions allowed for a fee.
- Gates: Caps on the amount redeemable during a specific period.
- Private Equity/Venture Capital:
- Liquidity: Lowest among all structures.
- Capital Calls: Investors commit capital and receive returns typically after 5+ years, with fund life often extending up to 12 years.
- Advantages:
- Enables long-term investment horizons.
- Reduces the risk of overreacting to short-term volatility.
- Allows managers to earn illiquidity premiums by holding illiquid assets.
- Disadvantages:
- Limits flexibility to adjust portfolio allocations in response to market changes.
- Reduces ability to meet sudden liquidity demands.
- Liquidity Terms:
Separately Managed Accounts (SMAs)
- Liquidity: Determined by the underlying assets’ liquidity.
- Advantages: Greater flexibility as securities can be sold at any time, subject to market conditions.
Management Fees
Fee Structures
- Mutual Fund Fees:
- Typically based on Assets Under Management (AUM).
- May require minimum balances.
- Fee options:
- Fixed dollar amounts.
- Percentage of assets.
- Advantages:
- Aligns with the manager’s skill in growing the asset base.
- Declining percentage fees for larger accounts reduce investor costs.
- Disadvantages:
- Luck can influence short-term AUM growth.
- Managers may focus on asset retention rather than taking beneficial risks for investors (e.g., favoring safe strategies like indexing).
- Performance-Based Fees:
- Fees tied to achieving specific investment returns.
- Advantages:
- Aligns manager and investor interests by rewarding performance.
- Disadvantages:
- May incentivize excessive risk-taking.
- Investors may end up overpaying for luck rather than skill.
Fee Misalignment
- Principal-Agent Misalignment:
- Investors (principals) and managers (agents) may have differing goals:
- Time Horizons: Disagreement on short-term versus long-term strategies.
- Risk Tolerance: Investors may prefer managers to take calculated risks, while managers may prefer safer approaches to retain assets.
- Transparency Issues:
- Investors may not fully understand the manager’s processes or workload.
- Luck vs. Skill:
- Performance-based fees risk rewarding managers for favorable market conditions rather than skill.
- Investors (principals) and managers (agents) may have differing goals:
Conclusion
Investment manager contracts must strike a balance between liquidity and fee structures to align with investor needs. Highly liquid vehicles like ETFs and open-end funds suit investors needing frequent access to capital. Limited partnership structures are better for long-term investors willing to trade liquidity for potentially higher returns through illiquidity premiums. Fee structures, whether AUM-based or performance-based, should incentivize managers to act in the best interest of investors while being mindful of misalignment risks and the role of luck in returns.
