Performance Fees

How do they usually work?

Typical performance fees will take a slug of a fund's performance above a certain benchmark. For example, a very active fund benchmarked against the FTSE350 index might take 20% of any excess return.

This seems fair doesn't it? 20% seems a lot, but after all we are talking about excess performance here. That still leaves 80% for us. What can possibly go wrong?

Here's the catch

The catch is what happens in the down years. The fund manager is not offering to repay us 20% of any underperformance. So he's taking a slice of the gains, but he's leaving us with all the losses.

Well, you might say, he has to take some sort of payment for his services. You'd rather it was in this form, related to the performance of the fund, than as a flat percentage.

Wrong. The 'performance' fee is related to volatility, not total return. Look at these examples.

If your fund mixes +10% years with -10% years (measured against the benchmark - not a bad performance, actually) the manager will take 20% of 10% every other year - average 1% annually. But if your fund mixes +40% years with - 50% years the manager will take 20% of 40% every other year - average 4% annually. Even though the fund itself will be going down the pan at 10/2 = 5% a year gross + 4% fee = 9% total. And your money with it.

It's actually worse than this. But enough maths for now.

....and the consequences are....

What investment style would you expect the manager to adopt under this particular 'performance' incentive? If he has a choice between a strategy giving a safe 8% annual return and another giving + or - 50%, which one do you think he's going to chose?

Why do you think hedge funds are so keen on this type of fee? How much money do you think the technology funds made in performance fees on the way up in 1999 before the bubble burst? Actually, you don't really want to know.

...to be fair to some funds

Some funds have performance fees where, after a payout, no further fees are paid until the fund returns to the previous trigger level (or 'high water mark'). This is much, much better. But the first year is still a one way bet. And each subsequent year still has a shot at doing better (think of a child on a swing). And if a fund falls too far below its high water mark after a few years it can always change its fee formula. Or merge into another fund. People have short memories

Selective nurturing

What's the game?

If a manager runs a family of ten boring old funds in a boringly average way he can expect at any time that five will be above average and five below. With any luck one will be a Star.

How can he can use this statistical inevitability to his advantage?

• He could advertise his whole fund family by quoting results only for the Star.

• He could liquidate the Dog and transfer its assets to the Star ("Our largest Fund ranks in the top 10% of all funds")

• He could liquidate any number of below-par funds to favourably skew the average performance of the family.

• He could keep starting funds with institutional friends as investors, kill the losers and run the winners. The performance of the winers can be used to pull in new investors.

....and that's why....

• Fund families tend to be so large. The more funds you've got, the easier it is to play this game.

• Fund managers have an incentive to take big bets, particularly in the early days of a Fund's life. If it goes right, he's got a Star. If it goes wrong, his mistakes are buried. Pity about the investors.

• Historical studies of performance are unreliable. They can be favourably skewed because the Dogs have all gone. It's called "survivorship".

The hidden rare event

If you played roulette without any knowledge of the numbers on the wheel, you might by observation come to the conclusion that putting equal amounts of money on red and black for each spin was a pretty safe strategy. Your money always seemed to come back.

That's when the zero comes up - wiping you out. It's only once every 37 spins (for a single-zero wheel) - just under 3% of the time - but it's enough to wipe you out. The zero is the "rare event". In this case not hidden, but you still need maths to cope with it.

What if a bank offered to invest your money for five years at an interest rate of 6% when the risk-free rate is 4%, but subject to a penalty of half your capital if at any time in the five years a major stock market index falls below 50%? You have no way of measuring whether this is a sensible investment. But the bank has.

It’s a human characteristic to underestimate the threat of rare events. It’s a bank’s job to make money.

The Smoothing Illusion

Smoothed investment products do not smooth. At best, they give you back what was yours in the first place (less fees). At worst, they level down.

What is smoothing?

Smoothing is a feature particularly of with-profits endowment policies or other unitised insurance products. These products invest your money in a general fund. The fund goes up and down. But your own investment return is reported to you each year as a small annual bonus.

You do not receive actual cash. When you withdraw you get your original investment, the accumulated annual bonuses and a terminal bonus.

The big question

In any supposedly smoothed investment, ask yourself: Who is picking up the downside tab? And why?

When times are good....

Now it's pretty clear how this works in the good times. Some money is always held back to cater for the slumps. When you withdraw it becomes safe to reveal your safety cushion and pay a terminal bonus.

But when times are bad.....

Why doesn't it just work the same way? Of course your terminal bonus will be small or zero, but at least you have a small positive return (the declared annual bonuses) in a falling market.

To answer this, you must ask the question: what should an investor do when he has bought a smoothed investment, received a few small annual bonuses and then seen the market collapse?

Clearly he should sell! Because if he stays in, any future gains will be used to offset the losses already made but not yet declared. Whereas if he gets out, he will be able to start afresh somewhere else, free and clear.

Or maybe you think past gains of the existing long term investors in the fund will be used to cover the losses of the new investors? In that case the long term investors should sell, to preserve their gains against the depredations of the new investors.

The fact is that after a bear market everybody should try to sell their smoothed investments.

The insurance companies have to prevent this. So they impose something called a Market Value Adjustment (MVA) on withdrawal. This is an exit penalty. It is no different from a negative terminal bonus. And it prevents the holders of smoothed investments from ever taking real advantage. Because the smoothing is an illusion, you see.

Levelling down

And when terminal bonuses are paid - whether positive or negative - do you think they fully represent the excess returns made? Or do you think something is kept back for a rainy day? Given that the actual performance of the funds is never revealed?

To sum up.....
So it is not too unkind to describe these smoothed products as follows:

• You give someone your money.

• They put it in a fund.

• They charge the fund for their services.

• You receive a letter once a year with a fantasy number in it. This is called the annual bonus. It is a fantasy because you cannot cash it in.

• When you want to realise your investment the amount you actually receive is adjusted by a positive or negative amount to bring fantasy back to reality.

• But not too close to reality. Just in case.

The lesson from 2000/03

Some truths can only be learned in a sustained bear market.

In early 2005 insurance companies announced cuts in bonus rates, despite the market having a very good 2004. And they were perfectly upfront about the reasons: they needed to recover the losses made in the post-2000 bear market. And MVAs (exit penalties, in other words) remained at around 20%. So you remained locked in with low bonus rates until the market recovery erased past losses.

So, as a buyer of a smoothed investment product in 2000 you would not have avoided the bear market; you would just have avoided being told about it.

To sum up...

These products only worked, if they ever did, because a) savers did not have the wish or knowledge or skill to 'trade against the institution' and, b) savers trusted the company to fairly distribute the proceeds of investment - taking (gently) from the lucky to support the unlucky.

Those days are gone.