What Henry V teaches you about performance-related fees

Shakespeare's Henry V follows on from the events of Henry IV, Part Two. The newly-crowned Henry V is persuaded by his advisers to invade France to pursue a dubious claim to the French crown. The French dismiss Henry as a leader, but he manages to take the town of Harfleur and wins the battle of Agincourt. This forces the French king to sue for peace, ceding control over large parts of France and marrying off his daughter Katherine to Henry. The play concludes with a reminder that the English gains would in the end be squandered.

The key moment

On the eve of the battle of Agincourt, King Henry walks on his own through the English camp, disguised as "Henry Le Roy", an ordinary soldier. He meets two soldiers, Bates and Williams, who discuss the upcoming battle. Bates and Williams argue that the king isn't being honest about their chances of victory and that, while they will almost certainly end up dead if the English lose, the worst that can happen to the king is that he will be ransomed. When Henry protests that the king will refuse any ransom, they reply "when our throats are cut, he may be ransomed, and we ne'er the wiser".

Lessons for investors

Most hedge funds (and a surprising number of investment trusts and open-ended funds) allow the managers to claim a certain fraction of the fund's performance, either in absolute terms or above a certain benchmark. This is meant to align the fund managers' interests with those of investors, and encourage them to take the bold decisions that lead to outperformance. But as well as pushing up costs for the investor, performance fees create a situation where managers get a share of the upside, but don't have to bear any of the fund's losses.

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Funds with "fulcrum" fees try to correct this by rewarding outperformance with a (capped) performance-related fee and penalising poor decisions by reducing the annual management charge. Academics Edwin Elton, Martin Guber and Christopher Blake found that between 1990 and 1999, US funds with such fulcrum fees delivered better net returns than other funds. However, even then the American funds that used a fulcrum structure didn't actually do better than the index, suggesting active management still routinely underperforms.