The stereotypical hedge fund fee structure is “2 and 20,” meaning a 2% fee on assets plus 20% of the gains. Typically gains are calculated above some threshold, particularly a high water mark. The purpose of the high water mark is to ensure the manager doesn’t get paid an incentive fee twice following periods of drawdown.
Long-only managers can charge incentive fees, too, although the structure is seldom as generous as “2 and 20,” and the measure is relative, not absolute. Absolute return managers might scoff at this, but the wealth preserving impact of beating a benchmark in down markets is undeniable. A 10% active return when the benchmark is down 50% is worth as much, in terms of relative wealth, as beating the benchmark by 20% when the benchmark return is zero, and as much as beating the benchmark by 25% when the benchmark return is 25%.
During the 2008 financial crisis, equity investors everywhere were reminded of some long forgotten differences in the properties of arithmetic returns from those of geometric returns. In short, not all returns are equal.
For example, assume a bear market environment and the benchmark YTD return is -40%, while an active manager’s YTD return is -30%. Subsequently, even on a day (or a month) when the manager underperforms, the manager’s YTD return advantage can still widen versus the benchmark. Let’s say the benchmark rebounds sharply and returns 2.50%, while the active portfolio lags, returning only 2.25%. The YTD benchmark return becomes 0.60*1.025-1 = -38.5%, while the active portfolio YTD return becomes 0.70*1.0225-1 = -28.425. The YTD active return actually increases from 10 percentage points to 10.075% and the manager’s incentive fee accrual grows accordingly.
If you’re scratching your head, wondering why a manager should deserve an incentive fee while losing money, consider this. Let’s say you’re a plan sponsor employing two active managers with the same incentive fee schedule against the same benchmark. Manager A is the active manager above. In 2008 he returns -28.425% versus -38.50% for the benchmark, while in 2009 he matches the benchmark return of 19%. Manager B matches the benchmark return in 2008 but beats it in 2009 by 10.075%.
The two-year return for Manager A, net of performance fee, is (0.8*0.71575 + 0.2*0.615) * 1.19 = 0.8277, or a cumulative -17.22% return. The two-year return for the benchmark is 0.615*1.19= .73185, or a cumulative -26.815% return, so even after performance fees Manager A preserved nearly 10 percentage points of the sponsor’s wealth. Manager B’s two-year return is 0.615*(0.8*1.29075+0.2*1.19) = 0.7814, or a cumulative -21.86% return. Both Manager A and B get paid incentive fees for the same return advantage, but Manager A’s value-added was nearly double that of Manager B’s.
In terms of economic value to the fund, managers ought to be paid on the ratio of their NAV to that of the benchmark, not on the difference in arithmetic return.