Know what performance fees you’re signing up for

Costs and fees are usually the biggest drag on investment performance over the long term. The higher the costs, the higher the return required for investors to make money. According to one study, only 17% of actively managed funds have outperformed their benchmarks over the past decade. This suggests that most managers are not worth the fees they charge. But that hasn’t stopped managers from charging over the odds for their services.

One trick is the annual performance fee. The idea of an annual performance fee makes sense when taken at face value. If a fund manager can outperform their fund’s benchmark, they deserve compensation for the effort.

However, it assumes investors only have a one-year time horizon and have invested at the beginning of the financial year. Investors shouldn’t buy a fund with a one-year outlook, and the chances of investing when the fund’s financial year ticks over are slim. If the manager outperforms in year one and underperforms for the next three, the performance fee paid in year one is rarely repaid.

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Even more damaging are intra-year performance fees, as presented in data from a team at University College London. The researchers ran millions of simulations to see how a series of fictitious hedge funds performed over 10 years with different fee structures. Although it’s now fairly uncommon for funds aimed at retail investors to charge performance fees, and most hedge funds don’t allow the average investor to invest, the results still present an essential lesson about the detrimental power of fees on returns.

The researchers found that highly volatile funds underperformed less volatile peers after performance fees were taken into account, even if they had the same long-term returns before fees. Returns were cut even further if performance fees were taken quarterly rather than annually.

For funds with a volatility of returns of 10%-20%, there could be a 10%-20% difference in the amount of money lost to fees when the fees were charged quarterly. For funds with a much lower volatility (5%, say), the difference was closer to 1%.

Over the long term, market returns average about 9% per annum, but within that figure, there is a lot of volatility. If investors miss one or two good days a year, it can seriously affect annual returns. Similarly, if investors miss one or two good years, it can have a major impact on long-term returns. If a fund charges a performance fee for a good year, or even a good quarter, it will bring down average long-term returns as it’s akin to taking money out at the top and not putting it back.

Impact of performance fees on long-term returns

Quarterly performance fees are far more common in the hedge fund and private equity worlds than in retail funds or investment trusts, but they do exist in both investment classes. Data compiled by Financial News shows that Abrdn registered £14 million in performance fees last year, while Schroders gathered £37.3 million in 2023.

Trusts that charge a performance fee include Pantheon International (LSE: PIN), which has a 5% performance fee that applies when the net asset value (NAV) returns 10% over the high watermark for the year. Seraphim Space (LSE: SSIT) has a performance fee of 15% over an 8% hurdle, also calculated on the NAV annually. BH Macro (LSE: BHMG), which owns units in the Brecon Howard hedge fund, pays a 20% performance fee to the managers on any profits.

One of the most egregious examples of the damaging impact of fees occurred when Chrysalis 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. Fees can be a good way of incentivising managers to outperform, especially in illiquid markets. Still, investors need to be aware of the effect of fees on long-term returns.

This article was first published in MoneyWeek's magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.