What is a performance fee?
A performance fee, for example, is compensation paid to an asset manager for achieving positive returns. In contrast to a management fee, which is charged regardless of the return, a performance fee is only paid for positive returns. A performance fee can be calculated in many ways. The most common is to calculate it as a percentage of investment gains, often both realized and unrealized. A performance fee is typically applied to active investment strategies to reward asset managers for positive performance.
Understanding performance-based fees
The rationale for performancefeesis that they align the interests of asset managers and their clients and provide an incentive for asset managers to achievepositive returns. For example, a “2 and 20” annual fee structure – i.e. a management fee of 2% of the fund’s net asset value and a performance fee of 20% of the fund’s profits – is a common practice for hedge funds.
Example of a performance fee
For example, if the asset manager receives a 10% performance fee and turns CHF 500,000 into CHF 600,000 within one year, he has achieved a positive return of CHF 100,000. He therefore receives CHF 10,000 or 10 % of CHF 100,000 as a performance fee.
The performance fee is suitable for mitigating conflicts of interest between the asset manager and the client. It is particularly obvious that the asset manager earns more money if the client also earns money and, of course, no performance fee is paid in the event of losses. But it is not a “panacea” for conflicts of interest. There are justifiably critical voices here too. For example, such performance fees for pension solutions have even been completely banned in Germany. This is because if an asset manager lives mainly from the performance fee, this can lead to a false incentive to invest short-sightedly and unsustainably in order to achieve the highest possible performance, whereby excessive risks could be accepted. In addition, a performance fee with a high watermark is (correctly) a one-off, non-recurring payment. The asset manager therefore has the incentive each time to chase high returns from one high watermark to the next by taking high risks.
In practice, this has resulted in some hedge funds, for example, repeatedly achieving exorbitant returns, but also repeatedly incurring spectacular losses precisely because of such incentive systems. If such a strategy fails, this also means that an old high-water mark seems almost unattainable. In other words, the hedge fund would hardly earn anything for a few years until it gets back above the high water mark. The hedge fund is then often closed in order to open a new one. The same “game” then starts all over again under a new name and the high-water mark is set to “zero” again.