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Five features of a fair performance fee, including a holiday

There is no standard method for charging performance fees on funds, and it’s likely most investors don’t know how their fees are calculated. What might look like a simple difference can cost investors dearly, and the impact may be more than the base management fee which receives far more attention.

Investors should at least know what a 'gold standard' looks like from their perspective, especially when funds with a well-structured high-water mark may not charge a performance fee for many years, offering new investors a special opportunity.

Should performance fees exist?

A reasonable justification for a performance fee is where the fund manager limits capacity because it operates in a universe with constraints on liquidity, such as in small or micro cap companies. This restricts the potential of management fees to grow based on overall fund size. An example is a small cap manager in Australia such as 1851 Capital which closed its fund to new investors when it reached $400 million (although existing investors can add money, making it a ‘soft close’). Its base fee is 1.25%, which on $400 million, is $5 million in fees. That’s not bad for a fund manager which opened its doors in February 2020 and now employs only three investment professionals but higher base fees could be earned without the close.

On this fund, investors pay a 20% performance fee for excess returns above the S&P/ASX Small Ordinaries Accumulation Index. 1851 manages only one fund which to 30 April 2022 had delivered 20.6% per annum after fees against the index of 7.1%.

My estimate is that returns before fees were about 25.25%, less base fee of 1.25% to give 24%, less the index of 7.1%, giving an excess of 16.9%, 20% of which is 3.4%. So the performance fee (not confirmed by 1851) is almost three times the base fee, taking total fees to about 4.6%.

This shows why it's worth capping fund size if a manager can deliver.

A common sharing ratio is 80/20, with 20% of the excess return over a benchmark accruing to the fund manager. If a fund manager delivers say 5% over the benchmark, most investors would be satisfied receiving an extra 4%. In his popular article, “My 10 biggest investment management lessons”, Chris Cuffe wrote:

Don’t be afraid of performance fees. I believe managers deserve their high fees based on their performance. In my own personal investment portfolio, I don’t care about paying a 20% performance fee (as long as the right hurdle exists) if I’m getting 80% ... I’m agnostic to fees so I just look for the best managers.”

How do performance fees differ?

Charging a fee sounds straightforward but it is anything but. I have been involved in drafting Product Disclosure Statements for platforms which offer funds from many managers, and the performance fee section is complex and convoluted. Most investors skip over it. The performance fee may be calculated:

  • before management fees*
  • after management fees*
  • over zero (commonly used for hedge funds or ‘absolute return funds’ which do not have a market index, or beta, exposure)
  • over the cash rate
  • over the bank bill rate
  • over an equity market index such as the S&P/ASX300 Accumulation Index or MSCI World
  • over an absolute return like 5%
  • inclusive or exclusive of franking credits
  • based on 10% to a mouth-watering 27% of the excess return.

*An example of the difference is: assume a fund has a management fee of 1%, delivers 2% above its benchmark, and a performance fee of 20%. If the performance fee is calculated ‘before management fees’, it is 20% X 2% equals 0.40%. If it is ‘after management fees’, it is 20% X (2%-1%) or 0.20%. Easy to overlook but double the fee.

What is the gold standard for investors?

Some investors might argue that the gold standard is no fee, as a base fee should be sufficient reward, and managers have enough incentive to do well.

But let’s look to the real world where some fund manager can change a performance fee due to their popularity. What are the fairest terms among an almost infinite array?

1. Outperform an appropriate benchmark

With few exceptions, an equity fund should not be benchmarked against a non-equity benchmark, such as the cash or bank bill rate.

Consider this from Sandon Capital (ASX:SNC). In its monthly fund reports, it rightly compares its performance against the All Ordinaries Accumulation Index, but what about the performance fee calculation? From its prospectus:

“Performance Fee - the Manager is also entitled to be paid by the Company 20% (excluding GST) of any outperformance over the Benchmark Reference Rate each year, subject to a high water mark.”

So far, so good. Delving deeper into the definitions on page 58 (where nobody goes) for the Benchmark Reference Rate:

“the average of each 1 month Bank Bill Swap Reference Rate published on the first day of each month across the Performance Calculation Period”

It’s an equity fund benchmarked against a bank bill rate, and one month is effectively the cash rate. In a year where the All Ords is up 20% and the bill rate is 0.1%, matching the index delivers 4% in performance fees.

Better to have something like this from Bennelong Concentrated Fund, which includes a hurdle over an equity index:

"15% of any amount by which the Fund's return is more than 2% greater than the return generated by the S&P/ASX 300 Accumulation Index."

Or a fund such as the Montaka Global Extension Fund (ASX:MKAX) which invests long and short and uses a 7% per annum absolute return hurdle.

2. Not charged on negative returns

It seems unfair that a manager who loses 10% should also hit investors with a performance fee, even if the market is down 15%. The client has lost 10% and further investor pain should be avoided rather than an additional 1% fee.

However, for example, in two pages describing performance fees in the Colonial First State Product Disclosure Statement which covers many funds on its platform, it says:

“It is also possible for the investment manager to exceed the relevant benchmark (and therefore be entitled to a performance fee) even where an option has had negative performance over a period, as that option may have performed better relative to the benchmark.”

3. Subject to a high-water mark with no resets

Performance fees should only be paid once the manager has recovered previous underperformance. This is called a ‘high-water mark’ because the highest price of the fund must be reached before the performance fee kicks in again.

For example, assume the market index is up 10% in the first year, while a fund is up only 5%. Then in the second year, the index is up 10% again but the fund rises a healthy 15%. Ideally, there should be no performance fee in the second year, because the manager has delivered index performance over two years (ignoring the impact of the base fee). In calculation terms, where the performance fee results in a negative dollar amount, it should offset entitlements to future performance fees.

Even if a fund seems to include a high-water mark, watch for it resetting to zero, either after a short period or due to a change in manager on the fund. The negative accrual is then removed. An example is Thorney Technologies (ASX:TEK). This is from its Annual Report, with the relevant part highlighted:

“A Performance Fee, the greater of zero and the amount calculated as 20% of the Increase Amount for the relevant period. The Increase Amount is the movement in the Measurable Portfolio value from the previous period plus or minus any applicable adjustments. The Increase Amount is reduced by the amount of Base Fee applicable to the relevant period. Measurable Portfolio includes measurable financial assets, including cash. If there is no Increase Amount for a financial period, the shortfall is not carried forward and not deducted from any increase in future financial period(s) for the purposes of calculating future Performance Fees."

There is no high-water mark in subsequent years. TEK could underperform by -10% in a year, then because the high-water mark is reset, there would be a 2% performance fee in the subsequent +10% period despite index performance over two years.

Perhaps this contributes to the relatively poor trading levels of TEK, with a share price of $0.28 and an NTA of $0.43, the discount is a hefty 35% at time of writing.

4. Smooth the impact over a vesting or measurement period

Another variation which seems fairer to investors is to smooth the impact of large performance fees over a vesting period, such as three annual payments. It defers the fees in case performance deteriorates. For example, if a fund outperforms by 15%, rather than paying a fee of 3% in the first year, it could pay 1% over three years. Then if it drops under the benchmark in the next two years, there may be no fee payable.

Another example is used by TDM Growth Partners, a Sydney-based investment firm specialising in global equities. It started the business with no base management fees and only fees for outperformance. However, realising it might not even cover its costs in a market downturn, it moved to a system where a base fee of 1.5% per annum is fully rebateable against performance fees to smooth its cashflows. It acts like a pre-payment of future performance fees.

5. A rationale for the fee

How does the fund manager justify including a performance fee? Limited market size? Alignment of interests? In most cases, it's to earn a higher fee from managing money.

The 'alignment of interests' argument is a stretch. If investors trust a fund manager with their precious retirement savings, and of course the manager wants to do as well as possible, there is already a significant alignment without the need to pay extra for performance. The reward is ongoing support from investors. 

It's more persuasive if there's a reduced base fee. The Information Pack issued for MySuper products includes this parameter:

"In any performance-based fee arrangement with a fund manager in respect of assets of the MySuper product, trustees must include ... a reduced base fee that reflects the potential gains the investment manager receives from performance-based fees, taking into account any fee cap ..."

If this is not included, then:

"a trustee must be able to justify that the differing arrangement continues to be in the best financial interests of the members of the MySuper product."

A performance fee holiday, but with a nasty sting

Following the rapid fall in the share prices of a wide range of companies since September 2021, many prominent fund managers who earned handsome performance fees in previous years are now in fee deficit. Their results in the 2022 financial year will be strongly negative.

Here is an opportunity for a new investor. If an investor enters the fund in FY2022, there may be no performance fee in FY2023 and FY2024 even if the fund manager outperforms in those new financial years. There will be a negative accrual from FY2022 in the future performance fee calculation.

Ask any fund manager for a list of funds with negative performance fee accruals.

However, this also demonstrates a weakness of pooled unit trust structures which Individually Managed Account-type products are designed to avoid. Performance fees in a unit trust must be calculated at the trust level as a whole, not by investor. The negative accrual from prior losses is shared with future investors in a pool, which may result in a return to paying performance fees earlier. This is a nasty sting for investors who lost money in FY2022 in the example above.

It’s a fee holiday … but some holidays are no fun

Investors willing to pay performance fees should at least know how they are calculated. Variations from the gold standard – a resetting of high-water marks or the wrong benchmark – could deliver bumper extra fees when performance is nothing special over time.

There is also the problem of giving the wrong incentives. A fund manager may swing the bat and fortuitously outperform and earn big fees, then the next year, the market gives all the gains back without a fee recovery for the investor. 

But where an investor is happy to back a talented fund manager who is going through a rough period, and especially if the base fees are lower due to the performance fee, there could be good opportunities to avoid a performance fee while previous high-water marks are recovered.


Graham Hand is Editor-at-Large for Firstlinks. This article is general information and does not consider the circumstances of any investor.


May 17, 2022

A number of undervalued LIC's have ongoing share buybacks.
These are purportedly to bring market values back to NTA values.
From a different perspective the manager is using shareholder funds to inflate the shareprice, so that higher fees may be paid to the manager.

The devil is in the detail with fund management. A lot can go wrong.

May 15, 2022

A good example is the Watermark Absolute Return Fund. A long/short EQUITY fund, with performance fees benchmarked against the RBA cash rate!! Interesting, to be polite.
Yes, an equity fund, performing as a hedge fund, where you pay a performance fee to beat a rate of 0.10% before May...
Page 20 of the PDS says the performance fee (20.5% -I love that little .5% above norm...) is calculated monthly and payable annually. However reading on, it says that it is calculated daily!
All subject to a high water mark of course. However the definition of the High Water mark says "High Water Mark means the highest NAV of the Fund AT THE END OF THE FINANCIAL YEAR where where a performance fee has been paid." (my bold.)
Graham, would be interesting to see the calculations.

May 13, 2022

Very hard to find this information, which I suppose is the point.
With LIC's, the fees often look biased unfairly. But then the dividend looks good.
Perhaps just another kind of dividend trap. Pengana (PIA) is an example I've been looking at.
It all looks attractive, but fees may soak up the growth. Very hard to tell.

May 13, 2022

John Bogle got it right many years ago. Very little has changed since.

Geoff Weaver
May 12, 2022

Performance fee = give me more money when the market is good and still give me money when the market is poor. That is investor has less upside and more downside. I'll take my own chances thank you.

May 12, 2022

Dash, I so love aligning my interest with a billionaire fund manager who needs to take a bit more of my return to have a symbiotic relationship with me.

Nick Everingham
May 12, 2022

Interesting article. When I had funds approach me with a proposal to allow for a performance fee I said no. I would only entertain their request if the fund had an “under-performance” rebate for investors.
None did.


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