How is the hedge fund performance fee paid?

Check performance fees

Fund fees are rarely the basis for decision-making

Basically, performance and income figures for investment funds are shown after deduction of management fees. This enables a fair comparison of the earnings development in the past. Because ultimately, performance counts after costs! In recent years, however, performance-based fee models have become increasingly established in Europe. For example, an outperformance fee is charged in addition to the annual management fee (as a percentage of the fund's assets). I. E. if the fund manager generates higher returns with the fund than the benchmark, the management company can charge the performance fee. Especially with hedge funds and other alternative investment products, there are very often performance fees and rarely comparable fee structures.

The London research company Fitzrovia estimates that in Luxembourg alone the proportion of funds with performance fees rose from 7% in 1993 to 15% in 2002. In Austria, the proportion of performance-based fee models for traditional investment funds is very low. The situation is different with hedge funds and alternative investments.

Different fee models make comparison difficult

There are no limits to your imagination when designing the performance fee models. Different models are possible. For example, an outperformance fee with or without a "hurdle". When installing a "hurdle", the fee will only be charged once this mark has been exceeded. This outperformance fee can also be capped or linked to the fulfillment of further conditions (e.g. positive total return).

Catch up on the underperformance first?

Investors should also check whether the distribution of opportunities and risks between the fund manager and the investor is fair. If a performance-related fee is paid in the event of an outperformance, it is interesting to see whether, in the event of an underperformance, these losses have to be made up again before the next outperformance fee can be charged. This is primarily related to the choice of the calculation period.

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Calculation period can be decisive

With classic fee models, management fees p. a. indicated and mostly charged to the fund in monthly installments. In purely mathematical terms, the administration fee is charged daily. This ensures that investors are neither preferred nor disadvantaged when buying and selling at different times.

In the case of performance fees, the calculation period can be of decisive importance.

Example: Outperformance fee with positive overall performance and simultaneous outperformance compared to the benchmark, calculated as a% of the outperformance over a period of 1 year. In the event of underperformance, no fee is paid and the calculation starts again from zero at the beginning of the next year.

With such agreements, fund managers could significantly increase the chances of outperformance fees by defining 3 month periods. The difference would be considerable, as the fund manager would now have 4 opportunities per year to pay an outperformance fee. The economic value of these additional possibilities can only be assessed with complex models of option theory.

Investors should analyze possible scenarios

Although neither the future development of the stock exchanges nor the future success of the fund manager can be predicted with certainty, investors should concentrate on the simple analysis of the four basic scenarios:

positive overall performance + outperformance

positive overall performance + underperformance

negative overall performance + outperformance as well as

negative overall performance + underperformance.

The results provide a first impression of a fair cost burden in success and failure.

Fitzrovia advises fund companies to review performance fees

The following checklist is suggested for checking the performance-related fees:

1. How are fees calculated? On the basis of profit or on the basis of total assets?

2. Is there a minimum outperformance ("hurdle") that must be exceeded before performance fees are paid?

3. Is there a benchmark performance index? If so, which one?

4. Are fees only paid for "new profits" or can the fund manager earn money with strong fluctuations in every upward movement?

5. Are all investors treated equally? Is the fee calculated and accrued on an ongoing basis?

6. Is there a maximum fee?

7. Are the annual management fees reduced in the event of underperformance?

8. Analysis of individual scenarios (as already shown above).

High water mark is in - upper fee limit (cap) is out

Fitzrovia found in a recent study that around 25% of the performance-based fee models include a "performance hurdle" (minimum outperformance). In classic funds, indices are very often used as a benchmark (45%). In the case of alternative assets, indices are rarely used (4%), but the "high water mark" is a fixed component of 87% of the funds analyzed. This means that a corresponding outperformance fee is only paid for new winnings and frequent ups and downs on the stock exchanges cannot lead to high performance fees. 53% of the classic funds also have "High Water Marks".

According to the motto "the sky is the limit", none of the alternative investment funds analyzed had a maximum performance fee and only 13% of the traditional investment funds provide for a performance fee limit.

Due to the tense economic situation at asset management companies, one can assume that the issue of performance fees will gain in importance in the next few years. The potential benefits of an innovative fee design are considerable.

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