While most managers appreciate it’s unreasonable to charge a performance fee when net returns are negative, they use 0% as a minimum hurdle rate, but this is still a lower rate than the return on a cash deposit.
Cash cow
A large fund can make significant amounts of money from performance fees, even if it is showing underwhelming performance. A €1bn fund with a 20% performance fee with a 0% hurdle rate that generates a net performance of 0.5%, can still generate €10m a year of performance fee income.
“Such a structure makes me more inclined to sell a fund. If they don’t deliver good performance, it turns into stealing money from investors. Many funds are struggling to generate performance, and will have to adjust their fee structure because of that,” says Marta Campello, a fund selector at Abante Asesores, a Spanish wealth manager.
Fund managers defend using cash hurdle rates by referring to their performance objective, which usually is to produce positive absolute returns. While capital preservation is the most important investment goal of most absolute return investors, perhaps fund selectors should insist their managers target a return that reflects this.
“Using a hurdle rate that tracks inflation rather than Libor would be fairer to investors,” says Jaakkola.
But fund managers are not likely to comply in a time asset manager profits are under increasing pressure, given the real risk that inflation will continue to outpace returns made by most absolute return managers. Some, however, are prepared to make some concessions.
High watermark
Many, but not all absolute return managers who charge performance fees use a high watermark, which guarantees performance fees will only be paid out once the net asset value of a fund has surpassed a previous high.
The Candriam Index Arbitrage Fund, which has more than €1bn in assets under management, has produced a net return of 1.67% over the last five years. Yet, it has been able to charge a performance fee of 20% in all but one of these years thanks to its cash benchmark. The fund doesn’t apply a high watermark, but that may change.
A Candriam spokesman said a high watermark had “never been an issue for clients” because the fund has outperformed its cash benchmark in all but one year since it was launched in 2003. Returns, however, have come under pressure in recent years.
“We might [therefore] consider introducing a high watermark in the future,” the spokesman said.
