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Performance fees correlated with underperformance, study finds

Investment funds that charge performance fees achieve worse results than funds that do not, a study has found.

In yet-to-be published research, Henri Servaes, professor of finance at London Business School, found that performance fee-charging funds return 50-70 basis points less after costs on average, compared to those that don’t.

Servaes, who looked at all Europe-based investment funds between 2001 and 2011, found that 7% of the 10,000 funds in his sample charged a performance fee. They often justified this by claiming that the fee would boost fund managers’ motivation, and that the management fee could decrease as a result.

However, the Belgian professor floored both arguments, as he found that the additional costs of a performance fee were not cancelled out by lower management fees.

“As a consequence, combined fees for funds with performance pay were 0.43% higher, and this largely explains the difference in returns between funds that do charge performance fees and funds that don’t,” he said.

Henri Servaes

Henri Servaes, London Business School

However, Servaes highlighted that not all performance fees were structured in the same way.

“Some funds charged a performance fee if they outperformed, while other based the fee on a ‘hurdle rate’, such as the risk-free interest rate,” he added.

He said he still supported the concept of performance fees, but only if their structure prevented managers making money from mediocre returns.

According to the professor, investment funds with a hurdle rate and a “high water mark” – in which case a performance fee is only paid if a fund’s value exceeds its highest value so far – performed better on average than funds without a performance fee.

They achieved an outperformance of 11 bps on average, he said. However, only a small minority of investment funds applied such a pay model.

Servaes added that he had failed to find evidence that investment funds charging performance fees were prepared to take more risk to increase their chances of receiving such a fee.

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