Unscrambling the performance fee egg yields new insights into hedge fund returns
Nov 25th, 2007 | Filed under: Investment Management FeesPerformance 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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[...] Gross hedge fund returns look more “normal” than net hedge fund returns. Are hedge funds defined by a fee structure? (All About Alpha) [...]
[...] The paper also points out the “smoothing effect” of performance fees (see related posting). “Particular circumstances may permit additional opportunities to dynamically manipulate the Sharpe ratio of a portfolio. Smoothing returns over time will leave the portfolio’s mean return unchanged but decrease its variance so smoothing returns will increase the Sharpe ratio. Funds with illiquid assets whose prices are only reported occasionally may benefit here. Hedge funds or other portfolios with high-water mark performance fees will also benefit. A standard performance contract calls for expensing the performance fee monthly but paying it only annually, but unpaid fees can be “lost†based on poor later fund performance. This contractual provision moves recorded returns from periods of good performance to periods of poor performance and smoothes the reported returns.” [...]