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Performance fee structures are great...for asset managers

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The last 20 years have seen a massive shift in the remuneration structure of asset managers from fixed percentage fees to a performance fee structure. Performance fees involve the payment of higher fees to asset managers when investment returns are higher. This sounds sensible, so it may surprise you to hear that I am yet to see an example of where it is a priori in an investor's financial interests to switch from a fixed fee basis to a performance fee basis (conversely, every example I've seen benefits the asset manager).

A reader's query

Let's couch this discussion as a reply to a reader's question. A reader said that he prefers a fund which has a hurdle rate for performance fees of CPI+8%, than another fund with a hurdle rate of ALSI+2.5%, as with the ALSI+2.5% fund you could still be paying performance fees when returns are negative (paying performance fees when returns are negative is unlikely, but not impossible for the fund targetting the Consumer Price Index + 8%). In this article, we examine which performance fee hurdle rate is better. For simplicity's sake, let's assume that the funds are alike in all respects other than the hurdle rate for performance fees.

Psychological benefits of a CPI + 8% hurdle rate

Other than in the very rare event of Consumer Price Inflation being less than negative 8%, with a CPI+8% hurdle rate you're not going to pay performance fees when investment returns are negative. This seems great, as when returns are negative the investment manager shares in your pain of losing money. This stands in stark contrast with an ALSI+2.5% hurdle rate; where if the ALSI returns -10% and your manager achieves -5%, you're still going to pay performance fees even though the manager lost 5% of your assets!

Performance fees don't impact performance of a quality manager

The timing & size of performance fees should have no impact on the investment strategy of quality managers. In fact, if a manager says that their investment decisions are different in instances where performance fees are involved, that's a strong indication that the manager looks after its own interests before its clients.

Note that a performance fee structure can worsen the behaviour of a low quality manager - for example, they might try to lock in gains so that they are paid out their performance fees, and double-up on their bets when returns are poor to try & get paid performance fees. 

What's the reason for performance fees?

The rationale from an investor perspective is that they want to reward good performance & punish poor performance, as this aligns the interests of the investor & the manager. Asset managers have also been keen to implement performance fee structures, as they see it as an opportunity to increase their fees. So, whilst the underlying intention of performance fees is sensible, most of the time they merely result in investors paying higher overall fees (even to poor managers) for the same performance.

We've discussed why the performance is the same, at least for a quality manager, but what are the reasons why performance fee structures result in higher overall fees?

  1. Asset managers ultimately want to maximise their profit, so will set fees at as high a level as they can get away with. Moreover, asset management companies abhor fluctuations in their fee income, so will want to be compensated more if a performance fee structure is introduced.

  2. Asset managers structure performance fees to reward themselves for volatility (luck) rather than skill

  3. Investors feel psychological relief at only paying performance fees when investment returns are good, and are willing to give away quite a lot in performance fees in order to secure a lower base fee. Like the punter at a blackjack table they are only too happy to throw a few chips the croupier's way when they have a good run.

  4. The impact of performance fee structures on overall fees over a full investment cycle (of positive & negative performance) is difficult even for trained professionals to fully comprehend. There is a massive asymmetry of understanding - the asset manager has a very good idea of what's going on, whilst most investors only have a superficial understanding.

In every single example I've ever seen of a manager switching from a fixed fee to a performance fee structure, it's been set up so that the manager will on average earn more.

Getting back to our reader's question

If a quality manager doesn't change its investment strategy based on performance fees, then, everything else being equal, it's better to invest with a quality manager with lower performance fees across the cycle of negative AND POSITIVE returns, rather than just focussing on minimising performance fees when returns are negative. 

The closer the hurdle rate for performance fees is to the actual stocks the manager is investing in, the lower the performance fees over the cycle. The more removed the hurdle rate is from the investible universe, the more performance fees reflect volatility rather than investment skill. For a manager investing in stocks on the JSE it's quite clear that the ALSI is far more reflective of the investment universe than the CPI index - stocks market returns can deviate massively from the rate of Consumer Price Inflation. Over time it's likely that the returns of a manager selecting stocks on the JSE will deviate less from the ALSI than from the CPI index. 

Therefore, whilst a CPI + hurdle rate may provide the psychological joy of not paying performance fees when returns are negative, over time it will probably result in higher performance fees being paid (than an equivalent ALSI+ hurdle) due to volatility relative to the hurdle rate, and fees paid may be less reflective of manager skill than an ALSI + hurdle (for a manager playing on the JSE).

Better performance fee structures

As mentioned the introduction of a performance fee structure is almost always a negative for the investor. However, some performance fee structures are better than others, For example, having hurdle rates which reflect the investible universe results in less bad performance fee structure. What other features are good to see?

The razzle dazzle of the asset management industry

"Give 'em the old flim flam flummox, Fool and fracture 'em, How can they hear the truth above the roar?"

Performance fees are just another example of razzle dazzle produced by the financial services industry.

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