Performance Based Fee Schedule

Sample Free Structure

$$ \begin{array}{c|c}
\textbf{Standard fee} & 0.55\% \\ \hline
\textbf{Base fee} & 0.25\% \\ \hline
\textbf{Sharing} & 16\% \\ \hline
\textbf{Breakeven active return} & 2.00\% + \\ \hline
\textbf{Maximum annual fee} & 0.69\%
\end{array} $$

$$ \textbf{Sample Fee Schedule} \\
\begin{array}{c|c|c|c|c|c|c}
\textbf{Active Returns} & \lt 0.25\% & 1.00\% & 1.50\% & 2.00\% & 2.75\% & \lt 3.00\% \\ \hline
\textbf{Billed Fee} & 0.25\% & 0.37\% & 0.45\% & 0.53\% & 0.65\% & 0.69\% \\ \hline
\textbf{Net Active Return} & \lt 0\% & 0.63\% & 1.05\% & 1.47\% & 2.10\% & \lt 2.31\%
\end{array} $$

The previous table demonstrates a basic performance-based fee structure. The standard fee of 0.55% is an alternative measure of what the fund could potentially be charging, perhaps as an AUM fee, it is for comparison purposes and not used in the calculations.

The Base Fee: This fee of 25 bps is the lowest the manager will charge under any given circumstance. This fee is both netted from the active return to calculate the performance fee and then added back in.

Sharing: This is the percent of profits the manager shares in. It is calculated based on the active return (what the manager returns less the base fee).

Breakeven active return: This represents the level at which the manager earns an approximately equivalent amount between the standard fee and the performance-based fee schedule.

Maximum annual fee: This is the fee above which the manager will not charge. This cap is put in place to help make the arrangement more symmetrical between the client and the manager. This is done in light of the fact that the manager would earn a positive return for negative performance.

$$ \textbf{Sample Fee Schedule} \\
\begin{array}{c|c|c|c|c|c|c}
\textbf{Active Returns} & \lt 0.25\% & 1.00\% & 1.50\% & 2.00\% & 2.75\% & \lt 3.00\% \\ \hline
\textbf{Billed Fee} & 0.25\% & 0.37\% & 0.45\% & 0.53\% & 0.65\% & 0.69\% \\ \hline
\textbf{Net Active Return} & \lt 0\% & 0.63\% & 1.05\% & 1.47\% & 2.10\% & \lt 2.31\%
\end{array} $$

In the leftmost column is represented the scenario in which the manager produces an active return of 25 bps. This still results in the minimum 25 bps fee, and the client is left with 0 bps as a net active return.

In the second column, the manager produces 1.00% as an active return. This results in a billed fee of \([(1.00\% – 0.25\%) \times 16\% + 0.25\%] = 0.37\%\).

This pattern continues until the rightmost column is reached. At this active return of 3.00%, the manager is earning 0.69% as a performance fee, the highest possible due to the cap. The client is left with 2.31%. Also, notice the manager needs to return just around 2.00% to equal the standard fee.

While this system is not completely perfect, candidates should be able to see why it is an improvement over the standard fee, which neither punishes a manager for poor performance nor rewards them for improved performance.

Question

In the previous example, a performance-based fee cap was used primarily to:

1. Earn the client a higher active return.
2. Comply with local regulations.
3. Make a more symmetrical fee structure.

Solution

The correct answer is C.

The primary purpose of using a performance-based fee cap is to create a more symmetrical fee structure that benefits both the client and the investment manager. It ensures that the manager is rewarded for good performance, aligning their interests with the clients, while also limiting fees in case of underperformance. This promotes fairness and ensures that the manager does not earn excessive fees if their performance does not justify it.

A is incorrect. A performance-based fee cap is not primarily used to earn the client a higher active return. It's actually designed to align the interests of the investment manager with those of the client by tying fees to the manager's performance. The idea is that if the manager does well and generates positive returns, they are entitled to higher fees, but these fees are capped to ensure fairness and protect the client.

B is incorrect. While local regulations and legal requirements can sometimes dictate the use of performance-based fee caps, they are not the primary reason for using such fee structures. Performance-based fees are typically chosen to create an incentive for the manager to deliver superior performance and are not solely driven by regulatory requirements.

Reading 13: Investment Manager Selection

Los 13 (i) Analyze and interpret a sample performance-based fee schedule