Understand the hidden charges in investment agreements
In the world of investments, performance fees are a common feature among many funds. These fees are charged on gains realized within a period, and when they are applied multiple times throughout the year (intra-year), they can have a significant impact on the long-term returns of investment funds, particularly those with high volatility.
Pantheon International, for instance, charges a 5% performance fee when the net asset value returns 10% over the high watermark for the year. Seraphim Space, on the other hand, imposes a performance fee of 15% over an 8% hurdle, calculated annually on the net asset value.
However, these fees can be detrimental, especially in volatile funds that experience larger swings. In such funds, fees may be paid repeatedly on interim gains, some of which are then reversed in losses. This frequent crystallization of fees during intra-year fluctuations can erode compounded gains more than in less volatile peers, leading to overall lower net returns compared to funds with similar gross returns but less volatility and fewer fee triggers.
This effect is related to the concept known as "fee drag," where frequent fee realizations disproportionately affect funds with higher intra-year volatility. For example, data from a team at University College London shows that intra-year performance fees can be damaging to returns.
The J.P. Morgan report highlights that despite substantial average intra-year drawdowns (14.1% on S&P 500), many years end up positive, illustrating that intra-year swings are common and could trigger fees if charged intra-year. Applying fees on such swings, especially in volatile strategies, can significantly reduce long-term results.
One notable example of the damaging impact of fees occurred when Chrysalis paid out £112 million in fees to managers based on its performance between April 2020 and August 2021, only to report a plunge in returns the next year.
In contrast, less volatile funds have smaller intra-year fluctuations and thus fewer instances triggering these fees within a year, preserving more of their gross returns for investors over time.
It's crucial for investors to be aware of this impact, as funds with intra-year performance fees may underperform over the long-term relative to gross returns, with the greatest impact seen in highly volatile funds compared to their less volatile peers, due to the repeated crystallization of fees during interim volatility.
High costs and fees can significantly impact investment performance over the long term. In fact, only 17% of actively managed funds have outperformed their benchmarks over the past decade. Returns are cut even further if performance fees are taken quarterly rather than annually.
In conclusion, while performance fees can incentivize managers to outperform, especially in illiquid markets, investors need to be aware of the effect of fees on long-term returns. It's advisable for investors not to buy a fund with a one-year outlook, as intra-year performance fees can be damaging to returns, as shown in data from various sources. Instead, a long-term perspective should be considered when making investment decisions.
Investment trusts, such as Pantheon International and Seraphim Space, impose performance fees on investors, which can have a significant impact on the long-term returns, especially in volatile funds. High costs and fees can erode compounded gains more than in less volatile funds, leading to overall lower net returns compared to funds with similar gross returns but less volatility and fewer fee triggers. Therefore, it's crucial for investors to be aware of the impact of performance fees on investment trusts and consider a long-term perspective when making investment decisions.
