In this section we discuss how performance fees are structured and how effective they are for managers and clients. Performance fees have become a more important factor in company earnings in recent years, but still vex those who invest in fund management shares. They can add significant volatility to the bottom line and reduce earnings visibility in a sector already seen as being somewhat at the market’s whim. However on the plus side they do not always seem to be subject to the usual competitive pressures. Interestingly, the evidence that they align manager’s interests with clients is weak at best, especially in the quoted sector.
How do performance fees work for asset managers?
Performance fees have become increasingly common in the asset management industry over the last ten years, though the history of managers taking a share of profits has a long history. In the 1950s A.W. Jones, often cited as the inventor of the hedge fund, charged his investors 20% of any upside he achieved.
While initially confined to the hedge fund industry and other alternative areas, such as private equity, the last decade has seen them spread into long only funds. This has been aided by legislative and market changes, with performance fees being permitted in UCITS. In the UK the lead has been taken by investment consultants, who dominate the institutional market. They are keen on the alignment of interests that performance fees are perceived to bring, though anecdotally this seems to be expressed as making fund managers share in failing to reach their outperformance target.
There are three typical structures for performance fees, though the details can vary considerably.
- Managers receive a percentage of the absolute return on the fund, if positive. This is the traditional hedge fund target and is often modified to have a surplus over a cash return (known as the hurdle rate.)
- Managers receive a percentage of the outperformance of the fund relative to its benchmark. This is the most common long only criteria, and almost the only one used in the institutional market.
- Managers receive a percentage of the outperformance of the fund relative to its benchmark, subject to the absolute value of the fund being higher then at the last time performance fees were paid out. This avoids managers being paid for outperformance when investors are losing money in absolute returns and is predominantly seen in retail funds, including some investment trusts.
There are of, course, many variations. For example the Schroder Oriental Income Fund has a hurdle rate of an annual 7% return distinct from its MSCI Index benchmark.
All funds now incorporate some sort of high watermark, so if the manager loses money or underperforms in one period, they have to regain that loss before they can earn further performance fees. The watermark can be absolute or relative.
There are two other criteria that have to be taken into consideration. The first is the rate of the performance fee. The original A.W. Jones figure of 20% has become the common figure in the hedge fund world. For long only funds with relative measures the rate is typically 10%. Many other rates are also seen, both higher & lower.
The second is the frequency that fees are collected. Most institutional contracts and investment trusts have an annual payout. Hedge funds often have more frequent payouts – semi-annual, quarterly or monthly. A third of Man’s AHL funds now have performance fees banked weekly. In the long run it shouldn’t make that much difference to the absolute amount of performance fees earned, but may affect their timing and so their short term volatility and present value. We look at this issue further in the next post on this topic.
Broadly performance fees are more popular among large, generally more sophisticated investors than smaller retail clients. For the latter they are seen by advisors as a possible barrier to sale, a complication that takes longer to explain. There are also cultural differences, with more acceptance in US and Europe but much less in Asia.
They have also been caught up in wider debate on remuneration in the financial services industry, with the mood against large payouts counting against them. Indeed we have recently seen some funds remove the performance fee element from the manager renumeration. Despite this, the trend still seems to be for more funds/contracts to have a performance fee element and it remains to be seen if recent events are just a sign of the times or the start of a wider change.
How do performance fees work for clients?
The theory is clear – performance fees align the interests of managers with clients by sharing the benefits of good returns between the two and so motivating the manager to produce better results. It is not entirely clear effective this is on manager performance – after all, very few fund managers don’t care about performance. They already know that poor performance will lead to the loss of assets, and that is a very strong motivation in itself. While the non-payment of a performance fee in an underperforming fund will give the client some comfort, it doesn’t solve the key problem.
Academic evidence on the relationship between performance fees and fund returns is limited, especially for mutual (long only) funds. Studies in the US & Italy suggest that on average mutual funds with performance fees have results that are no better than those without. For hedge funds there is some evidence of a correlation between the size of performance fee and the quality of performance.
There is a potential danger for clients. Performance fees can be considered as writing a recurrent call option at the funds expense. As with any option, its value increases as the volatility of the underlying asset increases. So a manager may be motivated to increase the risk the fund takes in order to maximise his fee value (to a lesser extent this is true for flat rate management fees as well.) This means there is an onus on the client to monitor the risks that their manager is taking, and one implicit way to reduce this risk is to have a significant fixed fee element as well, encouraging the manager to control risk to ensure retaining management of the assets. Academic research suggests that the presence of performance fees does increase fund volatility compared to those without – see here and here.
Where it may affect manager behaviour is in their asset accumulation plans. Most managers acknowledge there is a trade-off between performance and assets under management (AUM) – essentially large funds can find trading big volumes difficult and this can make it harder to achieve desired investment positions. Many managers close funds or strategies when have reached a size that would adversely affect performance. While assessing the capacity of a strategy is far from an exact science, there may be a temptation to sacrifice a little performance to get more fixed rate fees on a larger asset base. If performance fees would be lost in this process, then perhaps managers are more likely to err on the side of keeping returns higher and so AUM lower.
It is unclear how strong the trade-off is between performance fees and base management fees in practice and the degree to which aggregate fees reduce total returns. The stereotypical hedge fund fee basis of 2% (base) plus 20% (performance) gives a premium base fee to an average mutual fund and adds a performance fee on top – materially increasing the cost to the investor and reducing their total return. Where a fund has a good track record this drag can be increased even further – over time Man Group have managed to push the base fee up to over 350bps on AHL. At the other extreme there are a limited number of US hedge funds which only charge a performance fee.
In institutional lines performance fees are often set such that if the manager achieves the targeted outperformance then they receive the same amount as a fixed rate fee would give. In this case it is possible that in aggregate introducing performance fees may save clients money. If we consider that the average performance of all funds is likely to be in line with benchmarks then total fees will be lower than before as performance fees require a degree of outperformance.
This article is based on unused research for a client. Part 2 will focus on quantitative analysis and what performance fees are actually worth to a manager.