Benchmarks and performance fees
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