Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 196

Fairer performance fees for limited-capacity managers

Some years ago, we tagged the crowding out of super funds from investing in limited-capacity smaller funds as the ‘Allocation Gap’. Many larger funds and consultants like the performance of these managers but with insufficient capital allocation for a large super fund to move their total performance needle, it was not justified.

At the same time, limited-capacity managers did not want a concentration of money from a single client. Hence money stopped flowing to good small managers and alpha was left on the table for other investors, but not the big super funds. The Allocation Gap is still alive today, especially in the microcap space, except now there are further considerations around performance fees that challenge investors.

The investment rationale for limited-capacity equity investment managers is well known; small boutiques focused on less scalable ideas because of liquidity, for example. But to harvest good things in small packages requires a sustainable business model and appropriate pricing. In the case of microcaps, where liquidity is limited and managers need to cap their FUM, performance fees are widely used to bolster the business economics.

This practice should not bother serious investors provided the fee structures are fair.

Smaller companies can produce dramatic relative outperformance

As the table below shows, the performance of ASX small and emerging companies indices varies considerably relative to the broader All Ordinaries index. The relative performance of the Emerging Companies index and the other indices has been very high in the past 10 years, ranging from negative 33% (-15%) to positive 56% (+38%) versus All Ords and Small Ords respectively. When the smaller companies ‘run’ they can produce dramatic relative performance in both absolute and relative terms.

Further, the small and microcap managers’ performances can add an additional volatility in investor returns. It is well established that small and micro-cap managers outperform their relative benchmarks strongly in some periods and yet underperform in others, whilst importantly many outperform over the longer term.

A set of eight microcap managers we reviewed outperformed the S&P Emerging Market index by an average of 3 to 4% per annum during the past 13 years and by about 7% per annum over a 10-year period. Managers outperformed by double-digit amounts in some years and would have charged very high performance fees. In subsequent years, underperformance was common. Other research has found that smaller cap fund managers have a higher probability of generating larger value add compared to the average large cap fund manager.

Investors carry the costs of fee structure

The important point is that this manager excess return volatility can have significant implications for the investor’s periodic fee expense. With a typical performance fee of 20% in excess of the benchmark, a manager may earn a multiple of its base fee in one year only to underperform in subsequent periods. When the high-water mark recovery period is long, and it can be many years, it is the investor who carries the cost of having paid out for unsustained outperformance.

Such is the potential for high performance fees in bumper years — think 20% fee on excess performance of 10 - 20% — questions come to mind. Does the presence of a performance fee change a microcap managers’ behaviour? Further, can there be temporal alignment of interests between the manager and the client, when the shorter the period under review for paying out performance fees, the less reliable is the track record data. We know good managers can underperform or have very little value-add primarily because of market noise, and the reverse applies for unskilled managers who experience a run of better fortune.

Managers should smooth the impact

To deal with this, where performance fees are accepted practice (as with microcaps), we suggest smoothing the impact of large performance fees on the investor by staggering the payment of the fee for a vesting period after it is earned. For example, the manager might be paid in three one-third installments. This method could be applied over shorter or longer periods with different proportions and can be integrated into the high-water mark.

In the longer term, the manager will receive its duly-earned fee while the investor will incur a smoothing of the cost. The investor would have gained a put option by deferring the fees of the manager in case the performance deteriorates after the initial period (that is, strong first-year performance, say 10% excess return, is not followed through in the second and third year, say -5% in the second year and 0% in the third year).

Opportunity to harvest returns left by large funds

The Allocation Gap is crowding out big super funds from microcap alpha and beta opportunities because of their scale and the manager’s capacity allocation across clients. This is an opportunity for smaller funds and investors to harvest the returns ‘left on the table’ by their larger peers. Performance fees can be an acceptable feature of limited-capacity microcap funds, but it is important that the impact of high periodic performance fees on the investor is reasonable, as such performance is often not sustained.


Dr Steven Vaughan is Managing Director and Sriram Srinivas is Research Assistant at Queen Street Partners. This information is general only and does not take into account the personal circumstances of any individual.



Most viewed in recent weeks

Three steps to planning your spending in retirement

What happens when a superannuation expert sets up his own retirement portfolio using decades of knowledge? He finds he can afford much more investment risk in his portfolio than conventional thinking suggests.

Five stock recoveries not hanging on COVID predictions

The focus on predicting the recovery from the pandemic is the wrong emphasis. Better to identify great companies benefitting from market changes over a three- to five-year horizon with or without COVID.

Peak to peak, which LIC managers performed during COVID?

A comprehensive review of dozens of LICs shows how they performed in the crucial 'peak to peak' of COVID. This 14 months tested the mettle and strategies of a sector often under fire, with many strong results.

Finding sustainable dividend stocks on the ASX

There is a small universe of companies on the ASX which are reliable dividend payers over five years, are fairly valued and are classified as ‘negligible’ or ‘low’ on both ESG risk and carbon risk.

Blink and you missed a seismic shift in these stocks

Blink and it happened. If announcements in this sector were made by a producer of iron ore, gas, copper or some new tech, the news would have been splashed across the front pages. Have we witnessed a major change?

How inflation impacts different types of investments

A comprehensive study of the impact of inflation on returns from different assets over the past 120 years. The high returns in recent years are due to low inflation and falling rates but this ‘sweet spot’ is ending.

Latest Updates


Platinum’s four guiding investment principles

Buying mispriced stocks is often uncomfortable when companies are outside the spotlight and markets are driven by emotions. And it's inescapable that the price paid ultimately determines the end result.


Andrew Lockhart on corporate loans as an income alternative

Loans to corporates were the traditional domain of banks, but as investors look for income alternatives to term deposits, funds have combined hundreds of loans into a single structure to create a diversified investment.


10 things I learned in my faux-retirement

Pre-retirees should ‘trial run’ their retirements. All those things you want to do - play golf, time with the family, a hobby, write a book - might not be so appealing in reality, but you might discover other benefits.


Achieving a sufficient retirement income portfolio

Retirees require a reliable income stream to replace the wages they received when they were working and should focus on the dollar income generated over time rather than the headline yield percentage.

'Wealth of Experience' podcast and ASA webinar on ETFs v LICs

Peter reveals some top stock picks with an emphasis on long-term assets like Sydney Airport, Graham discusses spending in retirement and valuing assets, the key to Amazon, guest Andrew Lockhart and plenty more.


Lucy Turnbull’s three lessons on leadership and successful careers

From promoting women to boost culture to taking opportunities as they arise, Lucy Turnbull AO says markets should not drive decision-making and leaders must live and breathe the company's mission and values.


Are concerns about inflation inflated?

While REITs and some value stocks are considered 'inflation-sensitive' assets, the data provide little support that they are good inflation hedges, and energy stocks and commodities are too volatile. So what works?



© 2021 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.