Performance fees. No other words in the hedge fund lexicon seem to generate so much passion among both managers and investors.  But while the concept seems simple enough, it actually has implications well beyond the size of the manager’s bonus.

For example, a performance fee reduces return volatility.  In an up-month, the fee reduces the size of the return that might otherwise have been realized.  But in a down-month, the unrealized performance fee is essentially paid back to the fund - as if a negative performance fee had been charged.  Of course, after the fee is paid out at the end of the year, its gone for good and the worst a manager can do is to earn no performance fee the next year (see related posting for more discussion on intra-year negative performance fees).

Accounting for a performance fee can be a difficult task when conducting a back-test of a new trading model since the accrued performance fee in, say, December, would more than likely have impacted the manager’s strategy at that point.  So applying the same trading rules across the board and ignoring downside risk for the manager is unrealistic.

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