Understand the hidden costs of investment management agreements

Understand the hidden costs of investment management agreements

Impact of Intra-Year Performance Fees on Investment Funds

Investment funds with volatile returns and irregular profiles, such as private equity and certain hedge funds, may be adversely affected by intra-year performance fees. This is due to the fact that these fees are often charged and collected during the year when gains occur, even if those gains are later offset by losses within the same year.

This practice reduces the compounding effect over time compared to a fee structure that only charges on net positive annual results. In volatile funds, frequent fluctuations can trigger multiple fee events, draining returns. In private equity, performance fees (carried interest) are typically realized on gains upon exit; however, if fees are charged intra-year on interim valuations, it can also reduce net long-term performance.

Volatile funds and hedge funds are particularly vulnerable to this "fee drag," as losses that follow do not reverse fees already paid. This reduces overall compounding growth over multiple years.

In the private equity sector, performance fees (carried interest) are usually realized at exit. However, if fees or distributions occur on interim valuations, these can erode long-term returns since fees are paid before the ultimate realization of gains.

Active funds with high turnover and volatility may experience a higher frequency of fee events, amplifying the impact on net returns. Assessing fees in relation to alpha potential and cost-effectiveness is important.

Unlike flat management fees, performance fees can disproportionately reduce returns in years with volatile returns, resulting in lower compounded growth over time. While the search results do not explicitly focus on intra-year performance fees, the documented effects of volatility on fund returns and active management fees imply that frequent interim fees reduce the benefit of performance over the long term.

It is uncommon for funds aimed at retail investors to charge performance fees, and most hedge funds do not allow the average investor to invest. However, performance fees are more common in the hedge fund and private equity worlds, but they do exist in both investment classes.

For instance, BH Macro pays a 20% performance fee to the managers on any profits, while Seraphim Space has a performance fee of 15% over an 8% hurdle, calculated on the net asset value annually. Pantheon International charges a 5% performance fee when the net asset value returns 10% over the high watermark for the year.

Highly volatile funds underperform less volatile peers after performance fees are taken into account, even if they have the same long-term returns before fees. Missing one or two good days a year can significantly affect annual returns, and missing one or two good years can have a major impact on long-term returns.

Quarterly performance fees can result in a 10%-20% difference in fees lost for funds with a volatility of returns of 10%-20%, while the difference is closer to 1% for funds with a lower volatility of 5%. The chances of investing when a fund's financial year ticks over are slim.

Data from a team at University College London shows that performance fees have a detrimental power on returns. In the past decade, only 17% of actively managed funds have outperformed their benchmarks. If a fund manager outperforms in year one and underperforms for the next three, the performance fee paid in year one is rarely repaid.

The damaging impact of fees was evident in the case of Chrysalis, which paid out £112 million in fees to managers based on its performance between April 2020 and August 2021, only to report a plunge in returns the next year. Abrdn registered £14 million in performance fees last year, while Schroders gathered £37.3 million in 2023.

In conclusion, intra-year performance fees can significantly reduce long-term fund returns for volatile and private equity funds by charging fees on unrealized or temporary gains, inhibiting compounding, and increasing the cost burden on investors. Investors should be mindful of this when considering investments in these types of funds.

1. Investment trusts such as private equity and hedge funds, which have volatile returns and irregular profiles, may encounter challenges when investing with intra-year performance fees due to the escape of the compounding effect over time.
2. In personal-finance management, it is essential to assess fees in relation to alpha potential and cost-effectiveness, as performance fees in volatile funds can disproportionately reduce long-term returns.
3. In the business world, some investment funds charge performance fees, like BH Macro paying a 20% performance fee or Pantheon International charging a 5% performance fee when the net asset value returns 10% over the high watermark for the year. These performance fees, particularly in volatile and private equity funds, can reduce long-term growth due to their impact on compounding and the minimization of realized gains.

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