The perfect performance fee: Part 2

The key elements of a performance fee are the hurdle,  share of excess returns and high water mark.  Please see part one of this commentary if you need a refresher on these terms and general discussion on how a performance fee operates.  This commentary addresses the question of why funds have performance fees and reviews 4 reasons commonly held out by the industry.

Reason #1: only post fee returns matter

On the face of it this seems entirely fair.  Investors only care about actual post fee returns – how large the fees are and how the performance fee is constructed just shouldn’t matter.

But in reality it does matter.  There is plenty of research showing that the size of manager fees can be inversely correlated to after fee performance.  Intuitively this would seem to make sense – if an investor gives up 20% of the upside but keeps all the downside you must squew the risk / return profile of a fund.