It would be easy, but wrong, to say that all performance fees are bad.
Under the right conditions, performance fees can provide an optimal alignment between the strategy, portfolio manager, fund structure, and the interests of the underlying client.
Just the mention of a performance fee is enough to bring some people out in a cold sweat.
In its most egregious form, performance is measured against a risk-free (or other inappropriate) hurdle rate with no high watermark, the fee is paid in addition to a 75 basis point annual management charge, and the strategy has no meaningful capacity constraint.
Performance fees should be used to ensure that managers of high-performing, capacity-constrained strategies are compensated similarly to managers of benchmark-performing, high-capacity strategies.
Critics of performance fees point out that firstly, they pay the manager twice for just doing their job and secondly, they create a 'heads I win/tails you lose' asymmetry that encourages excessive risk-taking.
But these criticisms reflect a mismatch between the strategy, portfolio manager, and fund structure, rather than any inherent flaw in the idea of pay-for-performance.
To work effectively, a performance fee should be partnered with five non-negotiables:
- A low AMC to ensure that the manager is not paid twice. The right number is somewhere in between the fees charged by typical passive and active strategies (say 30 basis points).
- High water mark so that the fund will only charge a performance fee when the unit price is above the level that the last performance fee was paid. This means it must outperform on an absolute as well as a relative basis.
- Clearly identified capacity constraint that is consistent with the investment strategy. Many a fine strategy came unstuck when pushed beyond its natural capacity.
- Portfolio manager dines heavily, or better still exclusively, on their own cooking. This reduces the asymmetry typically associated with performance fees, thus providing insurance against excessive risk-taking by the manager.
- The strategy is designed to deliver performance that is materially different from the index. For example, it might have a focus on contrarian ideas, small caps, special situations or a concentrated portfolio.
Under such conditions, performance fees provide a much better alignment of interests than a flat AMC, which primarily incentivises the portfolio manager to spend their time marketing in order to grow AUM.
While researching this article, two further criticisms were proposed by professional allocators.
Firstly, the smoothing of OCF calculations in IFA client reporting means that in the years following the payment of a performance fee, the OCF will look extremely high.
Therefore, funds with a performance fee that have recently performed well are likely to exceed OCF budgets, while funds that have not charged a performance fee in recent years tell their own story. Either way, the odds are stacked against this fee structure.
Secondly, where a strategy delivers performance that is materially different to the index, the challenge of measuring relative performance is a red flag.
Mindful of this, the manager who is focused on building a successful business will happily design a strategy that best fits with allocators’ expectations of a low tracking error, while the portfolio manager who is doing it for the love of the game will gleefully accept the career risk and ignore benchmark constraints.
These criticisms illustrate the unintended consequences of well-intentioned but poorly designed incentives.
With client interests at heart, many industry participants have resorted to one-size-fits-all templates of what funds ‘should’ look like.
It’s important to deliver low-cost solutions, but blanket OCF budgets simply drive assets into passive strategies, as does an appetite for low tracking error.