|Performance fees are based on an
illusion. Avoid funds that pay them.
How do they usually work?
Typical performance fees will take a slug of a fund's performance
above a certain benchmark. For example, a very active fund benchmarked
against the FTSE350 index might take 20% of any excess return.
This seems fair doesn't it? 20% seems a lot,
but after all we are talking about excess performance here.
That still leaves 80% for us. What can possibly go wrong?
Here's the catch
The catch is what happens in the down years. The fund manager is
not offering to repay us 20% of any underperformance.
So he's taking a slice of the gains, but he's leaving us with all
Well, you might say, he has
to take some sort of payment for his services. You'd rather it was
in this form, related to the performance of the fund, than as a
The 'performance' fee is related to volatility,
not total return. Look at these examples.
fund mixes +10% years with -10% years (measured against the benchmark
- not a bad peformance, actually) the manager will take 20% of 10%
every other year - average 1% annually. But if your fund mixes +40%
years with - 50% years the
manager will take 20% of 40% every other year - average 4% annually.
Even though the fund itself will be going down the pan at 10/2 =
5% a year gross + 4% fee = 9% total. And
your money with it.
It's actually worse than this. We shortcut the maths
above. See Percentage
Games if you are interested.
....and the consequences are....
What investment style would you expect the manager to adopt under
this particular 'performance' incentive? If he has a choice between
a strategy giving a safe 8% annual return and another giving + or
- 50%, which one do you think he's going to chose?
Why do you think hedge funds are so keen on this type
of fee? How much money do you think the technology funds made in
performance fees on the way up before the bubble burst? Actually,
you don't really want to know.
...to be fair to some funds
Some funds have performance fees where, after
a payout, no further fees are paid until the fund returns to the
previous trigger level (or 'high water mark'). This is much, much
better. But the first year is still a one way bet. And each subsequent
year still has a shot at doing better (think of a child on a swing).
And if a fund falls too far below its high water mark after a few
years it can always change its fee formula. Or merge into another
fund. People have short memories.