When you invest, the fees that you pay matter. It is really important to understand the fee structures of your investments as not only do they impact the actual post-fee returns you will receive, but the structure inevitably dictates how the fund manager will behave with your money.

Performance fees are complex, on the surface I am completely on board with incentivising managers to perform because it can mean their interests are aligned with yours. In an ideal performance fee structure, better performance for you means more fees for them. However, not all performance fee structures are created equally. Performance fee structures can be complicated, and you need to understand exactly how they work, otherwise, you can end up with perverse incentives or structures that are largely in the manager’s favour and that simply hamper your post-fee returns.

When I am evaluating the performance fee structure of new investments for my clients, these are the characteristics that I want to see:

• A reasonable performance fee rate – most funds are 10% or 20% depending on the type of fund and the level of the management fee. More than this and I start to think the manager is getting a bit greedy.
• Are the performance fees calculated before or after any management fees? I feel that if it is calculated before management fees it is a bit like taking two bites of the cherry.
• An appropriate hurdle rate or benchmark– what this looks like depends entirely on the type of fund and what it can invest in. The hurdle rate could be cash, a set number, a plus CPI-type structure, or some sort of hybrid. Understanding what the hurdle is and making sure it is sensible is crucial because this is the level above which the fund manager can charge their performance fees. There are a couple of hurdle rates that I particularly object to especially when I am looking at an equity fund which has the ability to go long/short and leverage. Firstly, I dislike equity funds with a 0% hurdle rate, as we all know equity markets go up more than they go down, this is what makes them good investments so 0% really is not a hard target to beat! Not enough to deserve a performance fee. I also dislike a relative hurdles such as the performance fee being calculated relative to an index. Losing my clients less money than an index is not an achievement and does not deserve a performance fee. This is especially true when the equity fund has the ability to short.
• Calculated and paid annually. Some fee structures are calculated and paid more regularly than this (quarterly or semi-annually), in my opinion, this keeps the manager too focussed on the short term and allows them to lock in their fees very regularly. You are taking risks on their performance in the medium to long term, they should take risks on it too, rather than constantly “locking” in their fee.
• High watermark – how this is structured is critical to a fair and effective performance fee. A high watermark is the highest price of the fund which must be reached before the performance fee kicks in again. When a fund has a high watermark, performance fees are only paid once the manager has recovered previous underperformance. Last week, I looked at a fund with a performance fee above a 6% hurdle but with no high watermark. This means that each year the hurdle resets to 6%. This means the outcome could be that in Year 1 they make you 10% and charge a performance fee on the 4% above the hurdle. Year 2 they lose 50%, no performance fee as they did not pass the hurdle. If in Year 3 they once again they make you 10%, if they have a high watermark, they would not be able to charge you performance fees until the value of your investment reached the value achieved at the end of Year 1. But without a high watermark, in Year 3 they have once again achieved a return above the hurdle of 6% and can charge you a performance fee, regardless of the fact your investment is well below its starting position. Watch out for high watermarks that reset. The end result is often the same as having no high watermark at all. If you are going to invest in a fund with a performance fee it is critical that the fund have a well-defined high watermark with no reset.

Performance fee structures can be wordy and confusing. It is important to understand how a performance fee on any fund you are considering for investment is structured. You need to determine whether the performance fee for the fund is appropriate for what you are trying to achieve and for the type of investments it can make. I have seen a lot over the 30 years I have been involved in investing and one thing I know for sure is that the structure of performance fees matter. If you would like help in understanding the fee structures in your own wealth portfolio let me know.

Have a great week!

Shelley Marsh
Outsourced Chief Investment Officer (OCIO) & Founder
Wealth Differently

General Advice Warning: This information is of a general nature only and has been provided without taking account of your objectives, financial situation or needs. It does not represent and is not intended to be personal advice.  Because of this, you should consider whether the information is appropriate in light of your particular objectives, financial situation and needs.  We strongly suggest that you seek professional financial advice before acting.

Wealth Differently Pty Ltd AFSL 547820.