Two Things about Performance Fees

• Published in: Journal of portfolio management Vol. 38; no. 2; p. 4
• Main Author: Kritzman, Mark
• Format: Journal Article
• Language: English
• Published: London Pageant Media 01.12.2012
• Subjects: Asymmetry; Economic crisis; Fees & charges; Institutional investments; Investors; Monte Carlo simulation; Portfolio management; Portfolio performance; Profits; Standard deviation; Volatility; United States > US
• DOI: 10.3905/jpm.2012.38.2.004
• ISSN: 0095-4918

Institutional investors continue to allocate a significant and growing fraction of their portfolios to alternative investments such as hedge funds, private equity, and real estate, notwithstanding the challenges these relatively illiquid assets posed to them during the financial crisis. Managers of alternative investments typically charge a performance fee chat is a percentage of profits -- but not losses -- relative to a benchmark, along with a base fee that is a fixed percentage of assets under management. With the above assumptions, the asymmetry penalty equals about 0.70%. If the funds' correlations were higher, the penalty would be smaller, and if they were lower, the penalty would be higher. There is yet another subtle and unpleasant feature of performance fees. The standard deviation of funds that charge performance fees understates risk, because it is reduced by the attenuation of upside performance.