How Fund Managers Get Paid (And Why It Doesn't Align With Your Goals)

The quiet problem most investors miss

We assume that when we hire a fund manager, their interests align with ours. We both want the fund to perform well, right?

The reality is more complicated. Fund managers are paid based on assets under management, not on returns delivered. This creates incentives that can diverge significantly from what's best for investors.

How this actually works

Most fund managers earn revenue as a percentage of assets under management (AUM). If a fund manages $1 billion with a 1% fee, the management company earns $10 million per year—regardless of whether the fund goes up or down.

This creates several incentive misalignments:

Growth beats performance. A manager who attracts $500 million in new money earns more than a manager who generates 20% returns on a smaller fund. Marketing and sales often matter more to the business than investment results.

Size becomes the enemy. As funds grow larger, they become harder to manage effectively. Large positions move markets, good ideas become diluted, and nimbleness disappears. But closing the fund to new investors means capping revenue.

Short-term matters more than long-term. Managers are judged on quarterly and annual performance. Strategies that might work over 10 years but underperform for 3 years get abandoned because investors (and managers) won't wait that long.

Risk management favors the manager. A manager who takes big risks and fails loses their job. A manager who hugs the benchmark and underperforms slightly can keep collecting fees for decades. This encourages closet indexing—charging active fees while delivering passive-like results.

Where people get this wrong

Assuming good performance means aligned incentives. Even when a fund performs well, the manager may have been taking risks that weren't in your best interest, or their success may have been luck that they were incentivized to attribute to skill.

Believing performance fees fix the problem. Hedge funds often charge "2 and 20" (2% of assets plus 20% of profits). This creates an incentive to take excessive risks—managers share the upside but not the downside.

Ignoring career risk. Fund managers need to keep their jobs. This means avoiding strategies that might be right but could look wrong for extended periods. It also means following the herd, even when independent thinking would serve investors better.

What to focus on instead

• Understand how your manager gets paid. Is it purely AUM-based? Are there performance fees? How do the incentives shape their behavior?

• Look for skin in the game. Does the manager invest their own money in the fund? Significant personal investment aligns interests better than any fee structure.

• Consider index funds. Index funds sidestep the entire incentive problem. There's no manager making decisions that might be influenced by career risk or revenue goals.

• Be skeptical of fund size. Very large funds often suffer from their own success. The incentive to gather assets can work directly against performance.

How this connects to long-term outcomes

Incentive misalignment is a structural problem in the investment industry. It's not that fund managers are bad people—it's that they respond to incentives like everyone else, and those incentives don't always point toward your benefit.

Over a lifetime of investing, these misalignments compound. Funds that prioritize gathering assets over performance, that take excessive risks during good times, that cling to popular strategies rather than sound ones—these tendencies extract value from investors year after year.

Understanding how the industry actually works is the first step toward protecting yourself. You can't fix the incentives, but you can choose to invest in ways that minimize their impact on your wealth.

The question isn't whether your fund manager wants you to succeed. It's whether their incentives make your success the priority—or a side effect.