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THE ROLE OF BENCHMARKS in portfolio management and performance measurement is regularly discussed but it's less frequent to see a discussion of the impact that benchmark choice has on the fees an investment manager collects from his clients. The part of manager fee structures that's impacted by benchmark choice is performance fees, since those are usually levied on excess performance relative to a pre-specified benchmark.
In his paper Evaluating Benchmark Quality,1 Jeffrey Bailey states that a desirable benchmark should have, among other things, high overlap with the manager's portfolio, high power (in the statistical sense) to explain the portfolio's returns and a structure that reflects the manager's style bias. So when the style is outperforming the market so too should the benchmark. Moreover, whether or not the manager can beat the benchmark shouldn't be dependent on whether or not his particular style is in favour. A portfolio managed to a high quality benchmark will have lower tracking error than when the tracking error is measured against the market portfolio.
It's those characteristics when viewed in combination that are relevant in the context of the performance fee debate. Not only should the constituents of the benchmark represent the universe in which the manager intends to play but the risk characteristics of the benchmark - determined by its constituents, composition and style bias - should also bear a relation to the portfolio the investment manager intends to construct.
Investment management fee structures typically have two parts:
* A base fee: that's an essential component of the fee structure. If the base fee is too low the presence of a performance fee may give the fund manager incentives to assume unnecessary risks in order to achieve a higher level of fee income, or even to cover the daily running costs of the fund.
* An optional performance or incentive fee, usually defined by the benchmark or hurdle rate against which the manager's performance will be measured and the participation rate (the percentage of the performance above the benchmark that the manager will keep).
The performance fee benchmark or hurdle rate may or may not be different from the benchmark against which the manager runs his fund. Performance fee structures are most common in the hedge fund world, can be found in some pension fund mandates and are becoming increasingly prevalent in certain categories of collective investment schemes aimed at retail investors.
The hedge fund and segregated investment performance fee is usually perfectly fair, in the sense that the investor doesn't pay more performance fee than is justifiable in terms of the rand excess performance earned on his investment. That's possible because there's usually a small client base and fixed investment/redemption dates (in a hedge fund) or a single client (as in the case of a pension fund), making the application of a high water mark feasible. That prevents an investor from paying more than once for the same excess performance (for example, for retracing performance lost in a prior period of underperformance).
Managers who want to levy performance fees on their unit trust clients are faced with unique challenges. While it's easy to calculate the excess performance earned against a benchmark between two specified dates, it's less easy to ensure investors aren't prejudiced or advantaged on the basis of the net asset value when they invested. It's impossible to track the units held by individual investors in the same way an administrator tracks the individual series of the investors in a hedge fund, thus rendering high water marks impracticable for a collective investment scheme. The nature of the benchmark and the method that fees are levied become essential in that situation.
The vagaries of performance fee structures are the subject for another discussion: what we'll consider here is the choice of an appropriate benchmark.
It's well known that a standard performance fee structure can be thought of as a call option on the performance of the fund. If the fund underperforms the benchmark, the manager is not penalised; but if the fund outperforms he collects 20% (say) of that excess performance as fees.
The strike price of the option is the benchmark performance or hurdle rate; the term is the measurement period over which excess performance is calculated; the underlying instrument is the fund's performance; and the volatility is the volatility of the difference between the fund's returns and its benchmark - in other words, the tracking error of the fund. (See graph1).
Vanilla call and put options increase in value as volatility rises, essentially because extra volatility in the underlying instrument increases the probability the option will be in the money at the end of its term, making the option more valuable. The implication is that the long call option the fund manager holds on his fund's excess performance will increase in value with increasing tracking error to the performance measurement benchmark.
By simulating the behaviour of a fund manager who adds constant alpha but with varying levels of tracking error to his performance measurement benchmark, you can illustrate how the total performance fee take increases as tracking error (volatility) increases. The range of performance fee outcomes also increases, because with added tracking error comes added opportunity to underperform the benchmark.
In this simulation performance fees are levied on rolling 12-month outperformance of the benchmark, with no high water mark: consistent with many unit trust fund incentive fee structures. (See graph 2).
It should be noted at this point that you expect a relationship of that kind between incentive fees and tracking error and there's nothing wrong with a manager running his fund at a certain tracking error level because it's what he does or in order to comply with his mandate.
However, what is of concern is the practice of using your equity benchmark to manage an equity fund and another to measure its performance - and thus artificially inflating tracking error. An example would be a manager with his unit trust fund in the general equity category that manages his fund against the SWIX but calculates performance fees against the all-share index.
Though that may seem like an innocuous difference that isn't significant to clients of the fund but a general equity fund may have substantially different tracking error to the SWIX than it has to the all-share. Typically, if the manager is using the SWIX as his normal portfolio, the fund's tracking error against the Alsi will be higher. The manager thus takes advantage - knowingly or unknowingly - of that mismatch when reaping performance fees, as the extra volatility boosts his probability of ending the performance measurement period in the money.
The astute reader will have observed many hedge funds use decidedly non-volatile performance benchmarks or hurdles - cash or CPI+X% being examples. To reiterate, the signal difference between the hedge fund incentive fee structure and the structure that's possible in a unit trust fund is the high water mark. Use of a high water mark ensures while tracking error to the performance fee benchmark may be extremely high that error does not translate into extra fees.
Having identified the problem - excess volatility introduced into the incentive fee structure through mismatch of fund management and performance measurement benchmarks - we conclude with a recommendation. The possible variations in fee structures are endless. The issue we've dealt with here may seem trivial but it's for precisely that reason it often goes unnoticed. Time spent scrutinising any incentive fee structures to which your fund is subject won't be wasted. As with all commodities, it's important to understand what you'll be paying for - and when.
References:
1. Bailey, JV. Evaluating Benchmark Quality. Financial Analysts Journal. 48(1992b): 33-39.
Clare Johnson
JOHNSON is a quantitative analyst at Prudential Portfolio Managers. She's been working as a quantitative analyst for more than six years and holds an MSc in financial mathematics from the University of Cape Town.
