Fee Speech: Signaling, Risk-Sharing, and the Impact of Fee Structures on Investor Welfare

The fee structure used to compensate investment advisers iscentral to the study of fund design, and affects investor welfarein at least three ways: (i) by influencing the portfolio-selectionincentives of the adviser, (ii) by affecting risk-sharing betweenadviser and investor, and (iii) through its use as a signalof quality by superior investment advisers. In this paper, wedescribe a model in which all of these features are present,and use it to compare two popular and contrasting forms of feecontracts, the "fulcrum " and the "incentive " types, from thestandpoint of investor welfare. While the former has some undeniablyattractive features (that have, in particular, been used byregulators to justify its mandatory use in a mutual fund context),we find surprisingly that it is the latter that is often moreattractive from the standpoint of investor welfare. Our modelis a flexible one; our conclusions are shown to be robust tomany extensions of interest. The results are also extended toconsider unrestricted fee structures and competitive marketsfor fund managers.