Performance Fees

princeofpounds

I think he is either a fund manager or someone trying to justify their investment in one of those funds

I certainly don't invest in absolute return funds, as I pointed out above I don't advise them because most people do not require that level of diversification and they typically entirely misunderstand what they actually deliver (for example by comparing them to relative return strategies like a mutual fund).

princeofpounds

Consider for example a manager who is just short of the hurdle. He may then gamble on a particular investment in the hope of exceeding the hurdle and receiving a performance fee. However, if he fails he loses nothing.

You get so near to figuring this out and yet fall at the final hurdle. Interesting that this was the most thanked-comment when you realise its implication.

If you think it is fairest that the manager wins when you win, and loses when you lose, then that is an argument to have NO flat fee and TOTAL performance fee. When the manager outperforms the market, he gets fees and when he does not provide the service as advertised, he gets nothing.

The problem a lot of you are struggling to articulate is not a fee related to performance in itself, but the optionality of such fee structures, i.e. the fund manager does not share your losses as well as your gains. That's a valid point, but good luck in trying to find anyone who would bear such a risk. If they wanted it, they would just stick their own money in the market and forget about providing services to anyone else.

The discussion over whether 1.5% performance fees or whatever is too high is irrelevant. They might be too high, but that is a question of magnitude not structure.

princeofpounds

OK had a spare moment. This paper at least attributes performance fees as one explanatory variable of superior performance, although it was not enough to overcome other detractors and consistently outperform the market.

Unfortunately I can't load up the body of the paper.

http://www.jstor.org/pss/222427

princeofpounds

That's what the AMC is for.

Not an argument for a Performance Fee

It's not meant to be an argument for a performance fee.

The argument for performance fees is very simple. You want to align meeting your objectives with reward.

When your mandated objective is to outperform the market (as in most mutual funds) then an AUM charge doesn't make any sense, despite being the most common model.

If the market is up 30%, but the fund underperforms, the compensation to the manager RISES 30%.

If the fund makes an unparalleled 20% outperformance of the market, but the market falls 20%, then compensation to the manager FALLS ~10%.

AUM charges are like paying a company executive for the size of the company and not for its profitability.

Of course there are fixed costs which need to be covered, so there is a justification for some element of fixed charging. And it doesn't have any of the optionality problems that performance fee structures can have. But what it doesn't do is align interests.

StevieJ

What I struggle with is the current low hurdle e.g. Libor before performance fees kick in. BTW you never answered
my question about value of portfolio and relevance of absolute return.

RayWolfe

princeofpounds wrote: »

If you think it is fairest that the manager wins when you win, and loses when you lose, then that is an argument to have NO flat fee and TOTAL performance fee. When the manager outperforms the market, he gets fees and when he does not provide the service as advertised, he gets nothing.

I think few people would disagree with that. Are there funds like that?
What everyone seems to get hung up on is the win-win for the provider but a win-maybe-lose-maybe for the investor.
I thought the analogy of the restaurant earlier was interesting in not equating the cost of the meal to the price of the ingredients however, I think it fails when, if they produce a crap meal, you can argue about the price and/or the tip. If the fund produces crap performance, you've already paid.

fg22

princeofpounds wrote: »

Absolute return funds DO have a single strategy at core, which is to hedge out market exposure by offsetting long positions with short positions. Just because they use market instruments does not mean they bear market risk. Below is a starting point to understand this.

Most absolute return funds are not market neutral and do not claim to be so. Often they state that their aim is to achieve a positive absolute return regardless of market conditions, but this is not the same thing. Just compare the returns on the absolute return sector as a whole to the FTSE and you can see that market risk still exists although it is significantly reduced.

The argument for performance fees is very simple. You want to align meeting your objectives with reward.

But as I have stated they don't (at least not in their current form where there is a hurdle rate). My objective is to make a good return but also to limit my downside risk. Performance fees do nothing to align manager's interests with the second part of this objective.

AUM charges are like paying a company executive for the size of the company and not for its profitability.

Yes and no. If the manager performs well then NAV will increase and the only real way that a fund manager can try and increase the inflows into a fund is by showing a good performance (they are unlikely to have control over marketing). Chief executives can try to expand by lowering profit margins, mergers etc all of which can reduce shareholder value.


NB Fund managers' rewards aren't directly linked to the charges on funds but the only influence retail investors have over these rewards is by choosing funds by their charges.

Rollinghome

princeofpounds wrote: »

That is because it is not only absolute reward that is a valuable thing in an investment, but also the risk.

The virtues of an absolute reward is not the point in hand. Nor is it whether that particular Blackrock fund might go on to do better than it has done recently. It's the structure of its performance fees and whether a return of 0.25%, when that's far below the retail return available on risk-free cash and negative in real terms, is truely a performance so over and above the normal call of duty that it justifies an additional bonus on top of the already ample AMC.

You do retain some risk in an absolute return strategy, although saying that it is 'considerable' is totally meaningless. Risk numbers make little sense unless they are viewed in the context of portfolio theory. for instance, two risky but uncorrelated investments can be less risky than a single less risky investments.

The meaning of “considerable” is "to be worthy of consideration", and no more meaningless but rather more accurate than your previous claim that such funds have “little to no market risk” – which you sensibly now appear to have reversed away from.

One final word on 'considerable' risk - you can run an absolute return fund in a very risky or very unrisky way simply by scaling the bets.

I’m glad you see that now.

Because the remit of a fund like the Blackrock Abs permits both long and short positions does not mean it will be market neutral as you suggested or that long positions will always be hedged out with short positions - as can be seen from their reports.

Although absolute alpha uses market instruments it will, broadly speaking, be as short the market as it is long, and so have no net exposure.

The balance can be long or short and recently longs exceeded shorts 3 to 1.

jamesd

princeofpounds wrote: »

The argument for performance fees is very simple. You want to align meeting your objectives with reward.

And performance fees fail dismally at doing that.

Consider:

1. Leverage your fund with say an ETF tracker during a general growth market and make lots of fees for outperforming the benchmark.

2. Put some money in cash instead of the ETF tracker you normally use during a general down market and make lots of fees for outperforming the benchmark by falling less because less is invested.

3. Don't worry whether you miss the start or end, that just makes you a bit less money.

What matters in this is increasing funds under management so you can make more money with the leverage games.

They don't need it but I've a tip for all fund management houses: we're probably near the start of a growth cycle, it's a great time to rake in money from performance fees on equity funds linked to fixed interest targets like libor. Any mugs you can sell to will make you a lot of money from general stock market growth even if all you do is buy a tracker ETF and go to sleep.

A fund like BlackRock UK Absolute Alpha is doing rather more work and might well merit some linking of fees to performance. But are they really doing that much better a job than some of the existing people with great reputations going back many years who are on flat rates?

There's nothing new in this of course, HMRC uses it to make CGT revenue from inflation by creaming off a profit from assets that have been held a while before being sold.