Performance fees in asset management are a complex area, impacting the prices of both open-ended funds (unit trusts or OEICs) and close-ended funds (like hedge funds). Gautam Joshi, currently studying for the CISI’s Investment Operations Certificate, throws light on how performance fees work
What is a performance fee?
A performance fee is an incentive paid to a fund manager to grow the net asset value (NAV) of the fund. The rate (usually between 2-20%), period (usually quarterly), calculation method (variable based on nature of funds) and payment clauses are agreed with the fund in the prospectus. It is an expense for the fund and charged at share class level.
Say a fund’s start NAV is £1,000,000 and the fund pays 20% performance fees to the fund manager. If the fund’s NAV increases by 10% at the end of the quarter to £1,100,000 then 20% performance fees will be paid to the fund manager on the net increase of £100,000 i.e. £20,000 for that quarter.
Parameters of performance fees:
Start NAV is the base for calculation of performance fees which remains static throughout the period to compare with growth of the actual NAV of the fund at the end of the period. However, this can be revised every quarter based on pre-agreement.
High Water Mark (also known as net high values):
High water mark (HWM) is a maximum value of NAV in a given period. This is a previous best limit achieved by a fund manager and also revised every quarter. For example, if in the first quarter a fund manager achieved £150 per share then in the second quarter he has to achieve NAV more than this limit to earn performance fees. Hence, the target of the next best NAV always gets higher.
Benchmark (also known as index or hurdle):
The standard example of benchmark would be LIBOR or it could be an agreed rate. This is the index rate used to achieve the level of return e.g. 5% or 10% increase in NAV. The comparison with benchmark decides over/under performance of a fund. Some funds use daily/monthly or other periodic averages of the index rates such as three month’s LIBOR or the monthly Bank of Japan rate. The benchmark is agreed in the prospectus.
What is a minimum/maximum performance fee?
Some funds may set a maximum cap for performance fees to limit the total payment to fund managers. Some funds may set a minimum performance fee to secure a manager’s efforts to grow the NAV.
Crystallisation is a cut-off flag to end a performance period and start anew so that periodic payments can be made to a fund manager.
It is interesting to note that performance fees are not included in the ongoing charges and hence ongoing charges (also known as total expense ratio) of the fund may not indicate performance fees charged by fund manager. Investors must enquire separately for performance fees to come to a correct investment decision.
This article was submitted by Gautam Joshi, currently studying for his Investment Operations Certificate. If you are a CISI student member and are interested in submitting an article for the student newsletter please send your submission to email@example.com. If your article is published you will be sent a CISI pen and £25 vouchers.