# Risk-Factor Compensation for Active Managers: Pay for Alpha, Don’t Overpay for Beta, from John Netto

June 22, 2015 |

Two weeks ago in Chicago I presented the anchor leg of three different presentations on How to Identify and What to Pay for True Alpha.

Jason Roney of Bluegrass Capital Management and Marat Molyboga of Efficient Capital preceded me. Marat brought forth a very impressive presentation on assessing if manager skill actually exists and Jason showed how despite having a lower sharpe ratios, understanding a managers "regime robustness" is critical when making an allocation.

I concluded by presenting an incentive structure which one may use after they believe they have found an active manager worthy of investing in. My idea is "Risk-Factor Compensation". It's meant to be a very simple way to contextualize the profits a manager generates against not only the volatility the account had, but how much predetermined risk said investor was willing to lose. The resulting ratio then corresponds to a chart which tells what percentage incentive fee the manager is entitled to given their "Netto Number".

The bottom line is the current compensation structure of 20 percent of all profits without having a mechanism to contextualize how the return relative to drawdown or how much actual risk capital was at stake is woefully inadequate. I will post the link to the video when Terrappinn makes it available.

Given the sophistication of this group, I would like to hear anyone's comments on either the current 2 and 20 pay structure in hedge funds or my idea to have a score which balances out the focus between both the numerator and denominator as right now the only thing which matters when a manager gets paid is the numerator.

Here is the formula:

Profits / (Risk Budget + max negative drawdown/2)

So if someone made 400k and they had a risk budget of 800k and max negative drawdown of 400k then it would look like this

400k/ 600k

Which would equal .66. A Netto Number of .66 equals a 13 percent incentive fee, or 52k for the manager vs the traditional 20 percent of all profits, which would be 80k. So the investor saves about 28k in fees based on a lower Netto Number.

Now if the manager makes 1 mm and the denominators are constant then he has a Netto Number of 1.66 and now earns 32 percent of profits or 320k. But either way the investor wins because in order for a manger to get paid that the investor receives a SUPERIOR risk-adjusted return on a net basis.

I can email anyone privately the complete presentation upon request.

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