Bench­marks and per­for­mance fees

Finweek English Edition - - Property Compass - Clare John­son Pru­den­tial Port­fo­lio Man­agers

THE ROLE OF BENCH­MARKS in port­fo­lio man­age­ment and per­for­mance mea­sure­ment is reg­u­larly dis­cussed but it’s less fre­quent to see a dis­cus­sion of the im­pact that bench­mark choice has on the fees an in­vest­ment man­ager col­lects from his clients. The part of man­ager fee struc­tures that’s im­pacted by bench­mark choice is per­for­mance fees, since those are usu­ally levied on ex­cess per­for­mance rel­a­tive to a pre-spec­i­fied bench­mark.

In his pa­per Eval­u­at­ingBench­mark Qual­ity ,1 Jef­frey Bai­ley states that a de­sir­able bench­mark should have, among other things, high over­lap with the man­ager’s port­fo­lio, high power (in the sta­tis­ti­cal sense) to ex­plain the port­fo­lio’s re­turns and a struc­ture that re­flects the man­ager’s style bias. So when the style is out­per­form­ing the mar­ket so too should the bench­mark. More­over, whether or not the man­ager can beat the bench­mark shouldn’t be de­pen­dent on whether or not his par­tic­u­lar style is in favour. A port­fo­lio man­aged to a high qual­ity bench­mark will have lower tracking er­ror than when the tracking er­ror is mea­sured against the mar­ket port­fo­lio.

It’s those char­ac­ter­is­tics when viewed in com­bi­na­tion that are rel­e­vant in the con­text of the per­for­mance fee de­bate. Not only should the con­stituents of the bench­mark rep­re­sent the uni­verse in which the man­ager in­tends to play but the risk char­ac­ter­is­tics of the bench­mark ‒ de­ter­mined by its con­stituents, com­po­si­tion and style bias ‒ should also bear a re­la­tion to the port­fo­lio the in­vest­ment man­ager in­tends to con­struct.

In­vest­ment man­age­ment fee struc­tures typ­i­cally have two parts: • A base fee: that’s an es­sen­tial

com­po­nent of the fee struc­ture. If the base fee is too low the pres­ence of a per­for­mance fee may give the fund man­ager in­cen­tives to as­sume un­nec­es­sary risks in or­der to achieve a higher level of fee in­come, or even to cover the daily run­ning costs of the fund. • An op­tional per­for­mance or in­cen­tive fee, usu­ally de­fined by the bench­mark or hur­dle rate against which the man­ager’s per­for­mance will be mea­sured and the par­tic­i­pa­tion rate (the per­cent­age of the per­for­mance above the bench­mark that the man­ager will keep). The per­for­mance fee bench­mark or hur­dle rate may or may not be dif­fer­ent from the bench­mark against which the man­ager runs his fund. Per­for­mance fee struc­tures are most com­mon in the hedge fund world, can be found in some pen­sion fund man­dates and are be­com­ing in­creas­ingly preva­lent in cer­tain cat­e­gories of col­lec­tive in­vest­ment schemes aimed at re­tail in­vestors.

The hedge fund and seg­re­gated in­vest­ment per­for­mance fee is usu­ally per­fectly fair, in the sense that the in­vestor doesn’t pay more per­for­mance fee than is jus­ti­fi­able in terms of the rand ex­cess per­for­mance earned on his in­vest­ment. That’s pos­si­ble be­cause there’s usu­ally a small client base and fixed in­vest­ment/re­demp­tion dates (in a hedge fund) or a sin­gle client (as in the case of a pen­sion fund), mak­ing the ap­pli­ca­tion of a high wa­ter mark fea­si­ble. That pre­vents an in­vestor from pay­ing more than once for the same ex­cess per­for­mance (for ex­am­ple, for re­trac­ing per­for­mance lost in a prior pe­riod of un­der­per­for­mance).

Man­agers who want to levy per­for­mance fees on their unit trust clients are faced with unique chal­lenges. While it’s easy to cal­cu­late the ex­cess per­for­mance earned against a bench­mark be­tween two spec­i­fied dates, it’s less easy to en­sure in­vestors aren’t prej­u­diced or ad­van­taged on the ba­sis of the net as­set value when they in­vested. It’s im­pos­si­ble to track the units held by in­di­vid­ual in­vestors in the same way an ad­min­is­tra­tor tracks the in­di­vid­ual se­ries of the in­vestors in a hedge fund, thus ren­der­ing high wa­ter marks im­prac­ti­ca­ble for a col­lec­tive in­vest­ment scheme. The na­ture of the bench­mark and the method that fees are levied be­come es­sen­tial in that sit­u­a­tion.

The va­garies of per­for­mance fee struc­tures are the sub­ject for an­other dis­cus­sion: what we’ll con­sider here is the choice of an ap­pro­pri­ate bench­mark.

It’s well known that a stan­dard per­for­mance fee struc­ture can be thought of as a call op­tion on the per­for­mance of the fund. If the fund un­der­per­forms the bench­mark, the man­ager is not pe­nalised; but if the fund out­per­forms he col­lects 20% (say) of that ex­cess per­for­mance as fees.

The strike price of the op­tion is the bench­mark per­for­mance or hur­dle rate; the term is the mea­sure­ment pe­riod over which ex­cess per­for­mance is cal­cu­lated; the un­der­ly­ing in­stru­ment is the fund’s per­for­mance; and the volatil­ity is the volatil­ity of the dif­fer­ence be­tween the fund’s re­turns and its bench­mark ‒ in other words, the tracking er­ror of the fund. (See graph1).

Vanilla call and put op­tions in­crease in value as volatil­ity rises, es­sen­tially be­cause ex­tra volatil­ity in the un­der­ly­ing in­stru­ment in­creases the prob­a­bil­ity the op­tion will be in the money at the end of its term, mak­ing the op­tion more valu­able. The im­pli­ca­tion is that the long call op­tion the fund man­ager holds on his fund’s

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