Financial Engineering: The Evolution of a Profession

Chapter 23

Performance Fees

Mark P. Kritzman

Windham Capital Management LLC

INTRODUCTION

This chapter explores three aspects of investment management fees, which are not commonly understood. First, performance fees for a group of funds are higher than the average of the funds’ expected fees. Second, the standard deviation of returns net of performance fees understates a fund's exposure to risk. Third, typical mutual fund fees are as high as, or higher than, typical hedge fund fees. Allow me to explain.

PERFORMANCE FEES

Hedge funds typically charge a performance fee that is a percentage of profits—but not losses—relative to a benchmark along with a base fee that is a fixed percentage of assets under management. Often the base fee is deducted from the profits before the performance fee is applied. If, for example, the base fee equals 2 percent and the performance fee equals 20 percent, a hedge fund manager who produces a 7 percent return in excess of the benchmark on a $100 million portfolio will collect a $2 million base fee (2 percent × $100,000,000) and a $1 million performance fee [20% × ($7,000,000 − $2,000,000)], for a total fee of $3 million. The investor's return net of fees, therefore, is 4 percent in excess of the benchmark. Exhibit 23.1 shows fees as a function of relative performance given this particular fee arrangement.

Exhibit 23.1 Performance Fee Payoff Diagram