Management and Performance Fees in a Melon Fund

“teal body of water” by Miguel A. Amutio — High-water mark in a different context.

As the Melon Protocol marches towards its upcoming main net release, we would like to share some detail with you on a topic that is close to investors and investment professionals alike.

A fund is an invention borne out of considerations for efficiency. They gather together investors’ capital to deploy collectively. Fund managers can manage this larger collective capital more cost-effectively than if they were managing many, smaller individual accounts. So, how are managers fairly compensated when investors’ holding periods and amounts can vastly differ?

The traditional investment management businesses earn their income by charging investors fees for their services. There are many types of fees for various services, but the two main types are Management- and Performance Fees. The fee types are for the most part independent of each other and intend to reward different aspects of investment management.

Specifically, we are discussing fees that the Melon fund Investment Manager configures within their Melon fund to compensate the investment management services, expertise and skill they provide.

Melon funds do not try to reinvent the wheel when it comes to fees: the construction is smart and familiar, and the right balance of fees is fair for all participants.

Melon funds do, however, reinvent how these fees are paid by the fund.

Instead of using cash, or liquidating positions to pay fees, the fund smart contract itself calculates and creates new shares (or fractions), allocating them to the investment manager’s own account holdings within the fund. At that point, the investment manager can continue holding an increased number of shares in their own fund, or redeem the shares to pay their own operating costs, expand their research activities or whatever else they deem appropriate. The Melon fund smart contract autonomously and verifiably maintains the shareholder accounting impact in a truly reliable and transparent manner!

Paying fees in this manner has a few interesting and beneficial side-effects: Assets do not leave the fund, as would a cash payment. There are no unnecessary trading or cash management transactions. Investors and managers have access to real-time fee accrual metrics. Finally, the incentives to the manager are reinforced beyond a cash performance fee by being paid in the currency that is their own product.

Melon’s approach to Fees

Management Fees

Management fees are dependent on the amount of capital managed and the length of time it was managed. These fees provide stable and predictable income to the manager for their business operations, as long as assets under management remain stable. The investment manager charges the fund periodically for this fee, whereby the fund pays this fee out of cash or liquidates assets. In a novel twist, a Melon fund - as mentioned above - pays out these fees with the fund’s own shares. Also, the calculation granularity of a Melon fund will not be quarterly, monthly, weekly or even daily. Melon funds will calculate with seconds-level granularity. How’s that for precision?

On the Ethereum blockchain, each block records the time it was mined. The Melon fund smart contract records the time of the transaction which last triggered the management fee calculation. The difference between the previous and current fee harvesting transactions is the number of seconds a known quantity of shares were managed. Since management fee percentage rates are annual, we can easily calculate the percentage of the fund assets earned as the management fee by finding the proportion of a year that has passed, weighting the management fee rate by this proportion and multiplying by the number of shares managed since the beginning of this period (t=0). For simplicity, we assume for now that the number of shares remains constant over the period. Conceptually

The Melon fund smart contract creates the number of shares proportionate to this value, while holding the investors’s quantity of shares constant. The newly created shares are automatically allocated to the managers address and total fund shares increase by the same amount. Investors’ share quantities remain unchanged, but each share’s value is proportionately less as the direct result of the overall increased share quantity for management fee payment.

As a concrete example, consider a 2% annual management fee rate, Alice has 100 shares managed for 6 months by Bob. (1/2) x (2%) x 100 =1 share. But we need to maintain Alice’s share quantity at 100, so now there would be Alice’s 100 shares plus Bob’s 1 share earned. But 1 is not quite 1% of 101. Correctly, the Melon fund smart contract will create and allocate 1.0101 shares to Bob, while Alice’s account balance remains at 100.

Performance Fees

Performance fees depend, unsurprisingly, on the fund’s performance. To measure investment return performance, the industry generally uses two concepts introduced here: measurement period and the high-water mark (HWM). The measurement period is defined by the fund and is a periodic time interval that does not change, usually annual, but sometimes quarterly. Melon fund managers will discretionarily configure the measurement period to suit their own requirements.

The HWM is established at the beginning of a new measurement period. If the fund’s Net Asset Value (i.e. net of management fees) at the measurement period’s end is higher than the measurement period’s current HWM, the Net Asset Value becomes the new measurement period’s HWM and performance fees are charged. If this is not the case, there is no change to the HWM and no performance fees are charged. The HWM is like a step-function, which either stays flat, or in the case of positive performance, increases step-wise but never decreases. The performance fee charged is calculated as a percentage of the difference between the Net Asset Value and the HWM.

Returning to our example above, Bob has managed Alice’s investments for 6 months and a measurement period has come to an end. The performance fee is 10%, the existing HWM is 1,000 and a share now has a gross value of 1,100. To calculate performance fairly, we must first deduct the management fee. In value terms, this would look like 1,100 - 1% = 1,089, resulting in a performance of 1,089 - 1,000 = 89. If the performance fee is 10%, 8.9 would go to the manager and the NAV after deducting both fees is 1,080.10, which now also becomes the fund’s new HWM. In terms of share quantity, the Melon fund smart contract will create another 0.8323 shares, based on the already existing 101.0101 shares for a total of 101.8424 shares, of which 1.8424 shares, Bob has earned for investment management services and positive performance. This can be verified by taking total fund value (100 x 1,100 =) 110,000 and dividing by 101.8424 shares, resulting in our value-calculated NAV above of 1080.10.

A number of heuristic norms have evolved in the industry over time around fees. Actively managed funds charge higher management fees due to the higher effort involved, whereas passively managed funds are constructed to track a benchmark and require less effort, perhaps only periodic rebalancing. The standard for actively managed funds has been “2 & 20” (meaning 2% management fee and 20% performance fee), but this has come under pressure of late, as mediocre industry performance has caused investors to sharply monitor costs. Better performing managers have been able to charge higher fees, despite constant, fine-print reminders that “past performance is not an indicator of future results”.

In general, management fees provide sustainability to the business; the manager’s business (as a going concern) is also in the investors’ best interests. Performance fees incentivize a certain amount of considered risk-taking to motivate the manager, as investors earn as investment values appreciate with performance. This fee design tradeoff has proven to be a reasonable and fair mechanism to align the interests of professional managers and investors. Fair fees are, however, a requirement. It is worth pointing out, that a manager’s annualized performance must be greater than the annual management fee (and other operating costs, if any) in order to keep investment value above par.

Melon fund managers configure these fee rates at the time of fund setup. These fees are set at the discretion of the manager and, once the fund is deployed, they cannot be amended. The management fee, in particular, should be the result of careful consideration: annual performance must at least match this figure just for the investor to avoid losing capital.

The management fee shares are created by the Melon fund smart contract in an asset- and time-weighted flow. Certain actions, such as subscriptions or redemptions, trigger the calculation of share quantity and record it permanently to the blockchain.

Given positive performance, performance fee shares are created and a new HWM is set by the Melon fund smart contract only after the measurement period has ended. Again, this new share quantity is permanently and verifiably recorded on the blockchain.

It is important to remember that all of these components that are mission critical to fund operations - management fees, performance fees, NAVs, HWMs, shareholder accounting, etc., are all being calculated - autonomously, ultra-reliably, transparently, efficiently - by the Melon fund smart contract. Where once armies of accountants, controllers, structurers, auditors, lawyers, back-office- and middle-office workers spent hours faxing, calculating, checking and double-checking these metrics, now thumps the 14-second heartbeat of a public blockchain world-computer singleton doing the work without interruption - 24/7.

Move over Excel™, this jump is too big to be called an “evolution”.

For an in-depth view of the technical implementation, please visit the Fees section of the Melon Protocol documentation site: