Performance-based fees encourage several behaviors by portfolio managers, except which of the following? Select one
A. Hard work
B. Effort to earn high fee
C. Increased risk taking
D. Decreased risk taking
The correct answer and explanation is:
Correct Answer: D. Decreased risk taking
Explanation:
Performance-based fees are compensation structures that tie a portfolio manager’s earnings to how well the investment portfolio performs, typically relative to a benchmark or in terms of absolute returns. These fees are structured to motivate managers to maximize returns for their clients, but they also influence the risk behaviors of the managers.
Portfolio managers working under performance-based fee arrangements are generally encouraged to work hard and put significant effort into investment decisions because their income potential increases as the portfolio performs better. This directly aligns with option A (hard work) and option B (effort to earn a high fee), both of which are correct descriptions of behaviors encouraged by performance-based fees.
Option C, increased risk taking, is also a common result of performance-based fees. Since higher returns often come with higher risk, managers may be inclined to take on riskier investments in hopes of outperforming benchmarks or achieving high absolute returns. This is particularly true when managers are confident or when they are trying to make up for previous poor performance to reach a performance threshold or high-water mark.
However, option D — decreased risk taking — is not a behavior typically encouraged by performance-based fees. In fact, the opposite is more likely. When compensation is tied to returns, portfolio managers may avoid conservative investments with low volatility and low return potential because such investments limit their opportunity to earn performance fees. They may favor riskier assets with greater upside potential, even if that comes with higher volatility or potential losses.
In conclusion, performance-based fees incentivize hard work, a drive to achieve high returns, and a willingness to take on more investment risk. They do not encourage decreased risk taking, which is why D is the correct answer.