Performance-Based Compensation Goes a Long Way

Some alternative trading models use performance-based compensation for fund managers instead of flat fee compensation. This means the managers are paid only if they actually turn a profit, and the bigger the profit, the more they get paid. Traditional mutual fund managers receive some performance-based compensation in the form of bonuses. However, it is rare for a fund manager to be operating on 100 percent commission unless the fund uses a unique compensation model. When applied, this compensation model can drive results.

Psychology of Performance-Based Pay

The psychology behind performance-based pay is simple. The harder you work and the more efficient you are, the more money you will make. This model is used in nearly all forms of companies and organizations. Some professions, though, employ it to a greater degree. For example, salespeople are often paid with a performance-based model. This works in the sales profession because it keeps a salesperson motivated. Instead of just resting on commissions from accounts already earned, a salesperson has an incentive to go earn more. This is similar to the model used with fund managers.

Bonus versus Commission

Most fund managers can expect a bonus in a good year. However, in a bad year, they would still earn their salary and perhaps just a smaller bonus. With 100 percent performance-based pay, the manager is operating on a pure commission basis. This is often called the "eat what you kill" model. If a manager does not perform as well as last month, then she will actually be taking home a much smaller paycheck or no paycheck at all. Often, the base salary of a commissioned fund manager is simply a draw, meaning it is subtracted from the earnings at the end of the year. If the manager fails to profit, then he is in debt to the company for the draw.

Risks of Performance-Based Pay

Many investors will be happy with this model because it forces their fund managers to work truly hard. However, there are some risks as well. Since the manager's compensation is so tied to performance, she may be more likely to extend the funds into risky options. This is very true with hedge fund managers, who engage in short selling, derivatives-based trading and leveraging among other maneuvers to try to bank a profit. When the manager fails, they do not take the loss--the investor does.

Options for Performance-Based Pay

If you would like to buy into a fund with performance-based pay, you will generally need a high capitalization sum. Hedge funds are not usually open to investors with less than a few million dollars of capitalization. Mutual funds are more flexible, but the degree of performance-based pay is typically smaller than that of a hedge fund. When considering mutual funds with performance-based pay, ask whether the pay is structured as a bonus or as a commission-only position. This will give you insight into exactly how much motivation the manager has to perform.

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