Performance fees are charged to investors following good performances. Therefore they are considered ethically justified to the motto of: "I paid because I earned".
The truth is that performance fees (also known as incentive fees or performance fees) are mostly not understood: they can be punitive and go unjustifiably gobbling up large portions of your investments. For this to happen, it is enough to adopt the appropriate deleterious calculation mechanism. After reading this post I assure you that, based on numbers and facts, you will have changed your mind about performance fees.
What are performance fees
If envisaged, the performance commission is applied to asset management products, i.e. mutual funds, SICAVs, asset management and so on. The basic idea is simple: if the investment goes well and "earns", then part of the gain remains with the manager as a reward for his skill. It is a form of profit sharing, which should stimulate the asset manager to do well.
Usually the share of earnings that goes to the management company is between 10% and 20% and sometimes a portion goes directly to reward the management team. But, more and more often, this commission rewards the person placing the product, i.e. the seller.
This description is very rough, just to grasp the concept quickly (to say: I have deliberately not yet defined the "gain"). It is necessary to go into detail, to understand the perniciousness of some methods of calculating performance fees.
Performance fee bestiary
Performance fees are a premium on earnings. But what exactly is profit? It can alternatively be:
- the absolute performance of the fund;
- the relative performance, i.e. the difference between the return of the fund and that of the reference index, or benchmark.
A crucial point is then to understand how often the earnings on which the commission is taken are determined. This period of time is called the reset period and it is there that investment returns are played out.
In fact, imagine that the reset period is equal to one day: if the fund merely fluctuates randomly, generating positive performances one day and negative ones another, without adding any value, the commission would be withdrawn in the event of upward fluctuations. You immediately understand that it would only be a matter of luck and, given the volatility of the markets, the amount of commissions paid by the investor would be huge regardless of the skill of the manager.
It would be better if the gain were calculated over long periods. Or even only when new highs are reached, with the High Water Mark (HWM) mechanism: in this case, the incentive is withdrawn only if the value of the fund unit (or the difference in performance between the fund and the reference benchmark) has increased reaching new highs. In this way, skill is rewarded more than luck. But, even then, the fund could hit new highs, charge the performance fee, and then… roll back to previous levels. This can be avoided by making the performance fee symmetrical: if the manager earns, then he collects, if he loses, he pays.
But now, to better understand the essence of the various types of mechanism, let's touch the numbers with our hands thanks to some Monte Carlo simulation (write me in the comments if you want methodological insights, as the post is already longish).
Absolute performance fees
Let's imagine investing 10 euros for 10 years in a total return fund, on which, for simplicity, only the performance commissions are charged. The fund aims to obtain a positive performance but is not able to add value: in fact, in the simulation I hypothesized that the fund exhibits volatility (on average 7% on an annual basis), fluctuating over time, but that in the end it returns exactly to the point of departure, gross of fees. In other words, the average gross return for the period is zero.
Therefore, if there were no performance fees, investing 10 euros in the end would yield exactly 10 euros, perhaps with showy ups and downs along the way – as an example, the following graph shows a handful of investment trajectories gross (editor's note: gross) for the hypothetical fund.
Based on simple common sense, since this fund has zero added value, one can expect not to pay performance fees: in fact, there is no reward for any skill of the manager. That's why I chose this strange case.
Now let's see how much performance fees are in four emblematic cases: with a monthly reset period, annually, upon reaching highs with the HWM, and finally in the case of perfectly symmetrical fees, in which the manager pays if he loses. Since with the Monte Carlo simulation many "possible worlds" are obtained, in the following graph you will find various curves (probability distributions), one for each calculation mechanism. Commissions can take on a wide range of values, and the height of the curve is linked to the probability of occurrence.
Looking at the graph, a few facts immediately emerge:
- with symmetrical commissions, you rightly pay nothing (note a red "bar" on zero);
- in other cases you pay performance fees even if you shouldn't;
- this is due solely to the volatility effect, i.e. to the erratic behavior of the fund;
- the shorter the reset period, the more you pay, so the most unfair and incorrect method towards the saver is that of the monthly reset.
More precisely, in the simulation, with the monthly reset over 10 years, the highest point of the probability distribution is over 1000 euros: an average of 1035 euros of performance commissions are paid on 10 euros invested, corresponding to an abundant 1% per annum . A nice prize, for a fund with zero added value... essentially, money given "to dead father", as Totò would say. With the annual reset, the sum falls sharply to 285 euros (0,28% per annum), and with the HWM it drops to 144 euros (0,14% per annum). But it remains a positive sum. When it should be zero instead.
We increase the fund's volatility
Fund volatility plays a crucial role with performance fees. So let's see how much impact, repeating the previous exercise with a more volatile hypothetical fund, which invests in shares (annual volatility 20%).
It is immediately noticeable that the amount of absolute performance fees rises enormously. Therefore, the "dead father" performance fees increase with the increase in volatility and, more generally, in risk. Brace yourself: the average amount of commissions paid by the investor in the period with the monthly reset is 4270 euros (4,27% on an annual basis!). With the monthly reset, on the other hand, you pay 1174 euros (a substantial 1,17% per annum), which drops to 704 euros with the HWM (0,70% per annum). You only pay zero with symmetrical performance fees – and maybe now you know why you've never heard of them.
I hope the message is clear: the more volatility and risk an asset manager pumps into an investment, the more likely it is that he will get (and you will pay) performance fees. This is unexceptionable, and derives from the fact that, from a mathematical point of view, the economic result for the asset manager can be described with a convex function, and for convex functions Jensen's inequality holds, which tells us that the manager should increase the fund's risk as much as possible. It's not an opinion, it's a mathematical fact.
Now, if it is difficult to create value, almost everyone is good at generating risk. So: watch out. Because the performance fee pushes the manager to moral hazard, i.e. taking risks with other people's money to try to grab the performance fee. Then, it is said that the manager does not do it (there are valid reasons not to do it), but the risk exists: the asset manager is objectively in conflict of interest with the client. There are Hedge Funds which, following this logic, have taken on enormous risks not only with customers, but with the entire financial system, causing it to wobble, as in the case of Long Term Capital Management.
Related performance fees
Now let's imagine that the fund has a benchmark, i.e. an index to beat, and the performance fee is based on the difference in gross performance between the fund and the benchmark, the mythical "alpha". Assume that alpha is null (which is often true). Also in this case the manager does not add value, and the fund deviates from the benchmark for mere random reasons (the volatility of the deviations, known as tracking error volatility, is assumed equal to 3% on an annual basis). Let's repeat the usual exercise and see how it ends.
Here commissions drop sharply, even if the problems are analogous to the case of absolute performances: it is probable to pay even when there is no reason to; the shorter the reset period, the more you pay, and the more volatile the fund is relative to the benchmark, the more you pay. The HWM method is better than the others, except for the case of symmetric commissions – and this is a general result.
Speaking of benchmarks, however, a dark abyss opens up. Which should be used? Certainly not one too easy to beat, or totally unrelated to investment strategy. The choice should be consistent with the focus of the investment: for example, for a global equity fund it should be an international equity index, while for a total return fund it should be a monetary index plus a spread that is larger the greater the fund volatility.
Things you should note
Performance fees are widespread, and it would be foolish not to invest in a good product just because it is expected. Each management company can freely decide whether to apply them, establishing the methods of calculation; therefore the variety of algorithms is high. But now you should have the tools to orient yourself and discern pathological situations from physiological ones.
Basically, these are the highlights:
- check if and how performance fees are calculated;
- obviously, the lower they are, the better for you;
- the more risk the fund manager takes, the more likely you are to pay performance fees;
- the shorter the reset period, the more fees you pay and the more you should distrust the product, unless you love to blow your savings;
- for funds governed by Italian law, the Bank of Italy sets certain limits to protect savers, including the minimum reset period of one year;
- for funds incorporated under foreign law (the so-called "foreign-appointed" funds, for example domiciled in Ireland and Luxembourg), monthly or quarterly resets are also possible; so beware;
- symmetrical performance fees are finance-fantasy (rarer than a coelacanth), so don't bother looking for them, even if some funds are starting to apply "pivot fees", which provide for a reduction in the management fee in the event of a - performance of the fund;
- among the most common calculation methods, the HWM is the best, i.e. the fairest (but watch out, some operators carry out the periodic reset, resetting the performance counter – in this case, on average you will pay more);
- with related commissions, be careful that the benchmark is not a joke;
- the story that “performance fees are ethical” is a major lie; instead these commissions favor moral hazard, ie the assumption of risk at the expense of the customer, and are often paid for no real reason – if they tell you that's not true, spread them by saying that it can all be proved using Jensen's inequality. And then let's see.
SOURCE: AdviseOnly
