David Wright continues his analysis of the pros and cons of paying fund managers for how well they do.

Following on from the theme of our story in the last edition (February-March 2010), the proliferation of boutique funds man­agement businesses and the emergence of hedge fund products into the retail investor market has seen more managers introducing performance fees.  While the concept of performance fees ap­pears to have been broadly accepted by advisers and investors, in our observation, the operation and ultimate impact of these fees are not well understood.  

The main reason people have broadly accept­ed the concept of performance fees is that there is a general understanding that if the manager delivers strong performance then they will share in that performance via the performance fee; and if they don’t, they won’t.  Secondary to this is that most of the advisory market recognises that large levels of funds under management (FUM), particularly for Aus­tralian asset classes, make it increasingly difficult for fund managers to provide strong outperfor­mance of their underlying market benchmark.

Therefore, many believe that capping FUM ca­pacity and providing managers with some upside through a performance fee is a good thing and in the best interests of the investors.  It is not surprising that investors and advis­ers have a poor understanding of the operation of performance fees and their potential impact on after-fee returns, given the complexities and many “moving parts” of performance fee struc­tures. These can include the choice of perfor­mance benchmark or hurdle rate of return, the performance fee share, high water marks, reset periods, payment frequency – with many of these terms themselves not well understood. Given this lack of understanding of perfor­mance fees, we explore each of the components in more detail below.


The performance fee share is the percentage amount the manager will be paid if the fund outperforms its benchmark and meets any other required conditions.  By far the most common approach is for the manager to be paid 20 per cent of the outper­formance, with the remaining 80 per cent of outperformance being retained by investors. Investors should be wary of managers who take more than 20 per cent of the outperformance as this will start to impact heavily on the after-fee return they receive.


The selection of the perfor­mance benchmark or hurdle rate of return is core to the fairness or otherwise of a performance fee, because this is the rate of return with which the fund’s return will be compared to assess whether the manager will qualify for the payment of a performance fee. The most common practice is to measure the performance of the fund against the most relevant market index (for example, S&P/ASX 200 Accumulation Index for an Australian equities large cap fund).

Another common practice is to use a relevant market in­dex plus a margin (for example, S&P/ASX 200 Accumulation Index plus 2.0 per cent). This sets a higher return hurdle for the man­ager to beat before a performance fee will apply. For those funds that invest in multiple asset classes and investment strategies, such as fund of hedge funds products, and CTA (Commodity Trading Advisors), the usual approach is to use an absolute return hurdle (for example, the cash rate) as the performance benchmark.  Some managers use “tricks” when setting their performance benchmarks – things like using price indices rather than accumulation indices.

A price index is easier to outperform than an ac­cumulation index because the price index doesn’t account for the payment of dividends.  Another practice is the use of an inappropri­ate index or benchmark for the fund based on what it invests in. An example of this is a fund that uses the MSCI World Index $A as its benchmark, yet half of the portfolio is invested in Australian shares. Over the past decade this would have given the fund an easy benchmark to beat as Australian shares continued to outper­form international shares.  


Some performance fee structures have “reset periods”, where the perfor­mance period is reset each year or nominated period. This structure can potentially be very inequitable for investors if a manager underper­forms significantly in one year. They can “wipe the slate” clean and start again for the next year without having to recoup the underperformance for the previous year(s), yet still be eligible for the payment of a performance fee if they meet their criteria for the current year.

An extreme example of this could be an Australian equities fund, whose return declined more than 50 per cent following the global finan­cial crisis (GFC), being able to “reset” and then being paid a performance fee for the following year because it outperformed its benchmark and achieved a 25 per cent return.  Clearly in this instance, an investor who has been invested for the whole time is still down 37.5 per cent from the first year, yet the manager has been paid a performance fee for the second year! Fortunately this structure is not that com­mon but does exist.  


It is pos­sible for a fund to outperform its performance benchmark with a negative return (for example, fund performance is negative 10 per cent but the benchmark return is negative 20 per cent) and for the manager to still earn a performance fee.  This experience is obviously not very palat­able for investors. As a result, there are some performance fee structures that have a dual benchmark; that is, the fund has to outperform its benchmark and deliver a positive return to investors before the manager is eligible for the payment of a performance fee.


The concept of a high water mark was designed to overcome the potential for a manager to be paid a performance fee for outperforming their benchmark when the return to the investor is negative. Therefore, a high water mark is defined as the highest peak in value that an investment fund/account has reached. The unit price of the fund is often (but not always) the basis for calculating a high water mark.  Using a large cap Australian equities fund as an example, if the fund has outperformed its per­formance benchmark (S&P/ASX 200 Accumu­lation Index) at the time of measurement and the unit price of the fund is above its previous high (let’s use $1.50), then the performance fee will be paid.

If the fund has outperformed the S&P/ASX 200 Accumulation Index but its unit price is still below the previous peak (for example, $1.45) then a performance fee will not be paid.  While the application of a high water mark avoids the issue of paying performance fees when absolute performance is negative, it does not treat all investors equally, unless it is calculated on an account-by-account basis, or per individual investor.  The reason for this is that the unit price at the point of entry differs between investors, depending when they entered the fund.

In the example above this will mean that an investor who entered the fund at $1.00 will have achieved a better return than an investor who entered the fund when the unit price was $1.40, and yet the performance fee will be applied to both, because the manager has outperformed their benchmark in the period of measurement and the fund’s unit price is above its previous high. The only way to address this issue and make it fair for all investors is to measure the perfor­mance and high water mark for each individual investor. This is very onerous and many fund administrators are not able to administer it.


The performance measurement period and payment frequency are usually closely linked so that if the fund has outperformed its benchmark (and other conditions) over the period of measurement, the manager will be paid their performance fee at the same time. Ideally performance fees should be longer-term to ensure that managers are only rewarded for longer-term outperformance.  In practice this is rarely the case, with half-yearly and quarterly payment frequencies very common. While more frequent performance fee measurement periods help address the issue above – where investors entering the fund at different times experience different performance and performance fee issues – it can mean a man­ager is rewarded for short-term outperformance and subsequently underperforms for a longer-term period.

So while the concept of performance fees seems acceptable to many advisers and investors, and the approach can work for both investor and manager if the fee is structured fairly, this is not always the case.  The many characteristics of performance fees and the complexity involved in some structures means that not all performance fees are equal – far from it. In fact, in some cases the fee structure is downright punitive to investors and their after-fee returns.  The problem is that investors and advisers do not have the time or resources to properly assess the workings and likely impact of a performance fee. So when it comes to performance fees, it’s very much a case of caveat emptor (buyer beware).

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