ANNOUNCEMENT: Expert Investor is now PA Europe. Read more.

ANALYSIS: Are performance fees a fair deal?

Performance fees are often seen as a necessary evil. But the unambitious hurdle rates most funds employ mean fund managers also get rewarded for underwhelming performance. Is that fair?


PA Europe

Managers of alternative Ucits funds have imported the practice of charging performance fees from the hedge fund world, where the “two and twenty” rule (a 2% management fee combined with a 20% performance fee) remains sacrosanct even though hedge funds have suffered strong outflows in recent years, partly owing to complaints about exorbitant fees.

Not all alternative Ucits funds charge performance fees, however. For some reason, they are most common among long/short equity managers. More than 80% of long/short funds charge an additional performance fee according to Morningstar data, while less than a quarter of long/only European equity funds do so. 

A possible explanation for this discrepancy could be that “by introducing a [20%] performance fee, fund managers make room to charge a lower, more competitive management fee,” says Tero Jaakkola, a fund consultant based in Helsinki.

And it looks like Jaakkola has a point. Long/short European equity funds charge a slightly lower average management fee than their long-only equivalents (1.51% versus 1.65%).

High fees, low return

All in all however, total fees for absolute return funds (performance fees are relatively common in other parts of the alternative Ucits universe too) tend to be higher than for long-only fund charges.

“Fees on absolute return funds are generally very high. And the returns they are giving back to clients are generally not quite that,” says Michalis Fessas, head of fund selection at Eurobank in Athens.

Fessas adds: “If returns are low, a higher percentage is wasted by fees, be they performance fees or simple management fees.”Over the past three year-period, long/short equity and bond funds have both made total returns of less than 4% (see graph). And if returns are low, (competitive) fees become more important.

But in practice, Fessas isn’t too bothered with high fees. In the end, it’s the managers who shoot themselves in the foot if they overcharge.

“Our stance is that, if the net performance of a fund is good, then we can buy it regardless of the fees,” he says. 

“I believe the market can eventually regulate itself. If funds are really good, they can charge a performance fee. But if managers don’t perform and continue to charge high fees, the market will penalise them.”

Love for Libor

Long/short equity funds have indeed suffered outflows over the past 12 months, following a period of bad performance. If you strip out all the funds that have delivered negative real returns over the past year while still charging performance fees, you end up with very few to choose from.

That’s because almost all of these funds use a performance fee hurdle rate that is rather unambitious. As soon as a fund outperforms three-month Libor, the manager awards himself a 20% cut of this ‘outperformance’. It’s relatively easy, however, to do this as EUR Libor is currently negative, at -0.4%.

Read on the next page which changes fund selectors suggest to performance fee structures