ECON90034 Chap.10 Adverse Selection, Signalling and Fund Fees
Adverse Selection, Signalling and Fund Fees
Hidden information before a trade creates adverse selection. In Akerlof's market for lemons, sellers know the quality of their cars and buyers do not, so buyers pay at most the average value of the cars on offer. Because a lower price drives the best cars out first, the market can lose its high-quality trades or collapse to lemons alone, and the review lecture asks you to solve and explain such a model.
Signalling, screening, reputation and government certification are the remedies. The subject's case study, the VGI Partners fee terms, shows how a management fee, a performance fee and a high water mark shape a fund manager's incentives, and you should be able to calculate the fees. The fee example follows a fund through a gain, a loss and a recovery, the three situations the prospectus itself illustrates.
What this chapter covers
- 01
Hidden information and adverse selection
- 02
Akerlof's market for lemons
- 03
Equilibrium price ranges with several qualities
- 04
When adverse selection causes a welfare loss and when it does not
- 05
Signalling, screening, reputation and certification
- 06
Management fees and performance fees
- 07
The high water mark and how it resets
Worked example · free
When the good cars leave the market
- 1With every car on offer, buyers would pay at most 0.4 × 30 + 0.6 × 12 = $19.2k.
- 1That is below the $24k owners of good cars need, so good cars are withdrawn.
- 1Only lemons remain: they trade at a price between $8k and $12k.
- 1Each good car that does not trade loses $30k − $24k = $6k of surplus.
Key terms
- Adverse selection
- The tendency, under hidden information, for the goods or customers offered at a given price to be the worse ones, since the better ones withdraw first.
- Signalling
- An action by the informed party, such as offering a long warranty, that is cheaper for high-quality types and so reveals quality to the uninformed party.
- High water mark
- The highest portfolio value, net of performance fees, on which a performance fee was last paid; new performance fees are charged only on value above it.
- Performance fee
- A fee equal to a share of a fund's gains over a period, paid to the manager on top of the management fee and only above the high water mark.
- Management fee
- A fee charged as a percentage of the portfolio's value, payable whatever the fund's performance.
Adverse Selection, Signalling and Fund Fees FAQ
Does adverse selection always destroy the market?
No. If buyers' expected value of all the cars still exceeds what owners of the best cars need, every car trades and there is no welfare loss; the lemon owners simply gain. The loss appears only when good cars are withdrawn.
How is a performance fee with a high water mark calculated?
Take the portfolio value after management fees at the end of the period, subtract the high water mark, and charge the fee rate on the difference if it is positive. The new mark is the value net of that fee.
Why does a fund use a high water mark?
It stops the manager being paid again for recovering earlier losses. After a fall, no performance fee is due until the portfolio climbs back above the previous mark.
What are the remedies for adverse selection?
Contract design, gathering information through inspections or third parties, signalling by the informed side, reputation in repeated dealings, and government certification of minimum quality, as with food standards or the licensing of doctors.
How does a performance fee act like an incentive contract?
It ties part of the manager's pay to an outcome investors can verify, the fund's gains, just as an optimal moral hazard contract pays more after high output. The management fee works like a fixed wage, paid whatever the results.
What happens to the high water mark after a losing period?
It stays where it was. The manager earns no performance fee until the portfolio, after management fees, climbs back above that mark, and the next fee is charged only on the part above it.
Exam move
Practise the price-range table on a three- or five-quality market: for each price band list the qualities offered, their average value to buyers and whether trade can happen. Then practise fee calculations period by period, writing the close, the mark, the base, the fee and the new mark each time. Finish by explaining each fee in contract terms: which part is a fixed wage and which part rewards outcomes.
Keep the prospectus terms straight: a management fee on portfolio value, a performance fee each six months above the mark, and both quoted before GST.
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