This business case outlines how our asset allocation models can help fund/hedge fund managers to enhance their performance. Our business case discusses assumptions, performance measures, fee calculation and simulation results. It also considers also the benefits our models would bring to fund/hedge fund managers’ fees and their fund size if applied.
Fund managers typically charge their funds both a management fee and a performance fee. In this business case we present the results of investing with our models to those fund managers whose are willing to enhance their performance and increase their profit from fees. We also aim to show how fund managers can benefit from investing using our quantitative models and we lay the ground rules of how we can improve the managers’ performance and profits.
When a fund is outperforming its benchmark (Hurdle Rate) in a rising market, it can be argued that performance fees provide investors and managers with a win-win situation. Typically, the manager is paid a proportion of the total amount by which the fund outperforms (Alpha) its benchmark. These performance fees provide an incentive for the manager to generate Alpha (rather than just absolute returns) on the basis that the fund manager will be rewarded for his superior skills.
When the fund outperforms its benchmark in a falling market (with the fund showing negative returns), it can be argued that performance fees should not be paid to the manager who is losing the client money. However, in this document we also consider the case where the investor would benefit from a fund which outperforms the benchmark in spite of negative returns.
Assumptions
The following assumptions have been made for the purposes of our business case:
1. Fund/hedge fund managers may charge a % management fee and/or a % performance fee.
2. The management fees are calculated as a percentage of the fund’s Net Asset Value (NAV) and typically are 2% a year. The management fees are paid whether the fund makes or loses money. These fees aim to cover the operational costs of the fund and a proportion of the fund manager’s profits.
3. The performance fees are typically 20% of the returns above the Hurdle Rate during any year. These fees include a hurdle, so that a fee is only paid on the fund’s performance in excess of a benchmark rate. This ensures that the manager is only rewarded if the fund generates returns in excess of the returns that the rational investor would have received if they had invested their capital elsewhere.
4. We have used the S&P 500 Total Return as benchmark.
5. We have assumed that management and performance fees are calculated and paid on an annual basis for simplicity. Management fees are paid at the beginning of the year while the performance fee is calculated at the end of the year.
6. The manager has flat transaction cost fees for 0.8% per year of the fund value, i.e. of the NAV.
We have also considered the case for a High Water Mark whose function is to ensure that a manager who has made money for an investor and then loses part of that capital cannot take a performance fee until the loss has been made up. This is needed to avoid the situation where the benchmark falls by 40% and the fund only falls by 30%; the fund has outperformed its benchmark by 10% but has still lost the investor money.
This means that a performance fee only applies to net profits. This fee is paid on positive returns where the fund outperforms both the benchmark and the High Water Mark. This avoids a situation where the client would be charged a fee while a fund is declining.
However, one could argue that since the manager’s client could alternatively invest in the SPDR S&P 500 (SPY), in a falling market, a smaller loss is a gain for the next period e.g. if the benchmark falls by 40% and the fund falls only by 30%, the following year the manager would need to achieve smaller returns to break even. For example, with a 40% drop in the SPY, $100 would become $60 while with a 30% drop in the fund, $100 would become $70. In the next period, if the SPY grows 50%, $60 will become $90 while it would need only 30% growth for the fund to get back to $91 thereby outperforming the SPY on a two year basis.
Fee calculations
In general, funds are typically open-ended, meaning that investors can invest and withdraw money at regular intervals e.g. end of the month. However, in our calculations we assume that throughout the year the monthly capital outflow equals the monthly capital inflow i.e. the invested capital is the same as at the beginning of the year.
Performance measures and results
We have applied the above rules to one of our models to estimate what the manager’s fund performance would look like if we make the above assumptions.
On the following pages we present the results for the five different fee regimes which are based on what has been discussed so far and on the parameters below:
1. 2% management fee:
• 2% management fee
• 0.8% in operational costs
2. 2% management fee and 20% performance fee with Hurdle:
• 2% management fee
• 20% performance fee on Alpha
• 0.8% in operational costs
3. 20% performance fee with Hurdle:
• 20% performance fee on Alpha
4. 2% management and 20% performance fees with Hurdle and High Water Mark:
• 2% management fee
• 20% performance fee on Alpha with High Water Mark
• 0.8% in operational costs
5. 2% management and 20% performance fees on absolute returns:
• 2% management fee
• 20% performance fee on Alpha
• 0.8% in operational costs
As mentioned above, management fees are paid at the beginning of the year while the performance fee is calculated at the end of the year. Both are calculated on the NAV which grows at the rate of change of our model.
Conclusions
Unless the fund manager is able to consistently deliver Alpha, a rational investor should not invest in his fund. Rather the investor should invest in an Exchange Traded Fund (ETF), able to track the S&P 500 Total Return e.g. the SPDR S&P 500 (SPY).
Tables 2.1a and 2.1b below show the results of our fee calculation from 1942 to 2017 while table 2.2 considers only the last 10 years (2008-2017). The aim of this exercise is to capture different possible fee regimes used by different fund managers.
From the results below it can be clearly seen that the fund NAV performance is better that the S&P 500 TR in all five cases although the results are different. Options 2) and 5), for example, favour the manager rather than the client while options 1) and 3) favour the client and not the manager.
However, with a fund growing at 14.6% or 15.1% compound annual rate of growth, it is arguable that the manager would gain in the medium and long run by attracting additional capital to their fund and gaining in this way from economies of scale.
Our models offer the fund manager the opportunity to enhance their performance thereby attracting more capital. In this way the managers of large funds would be able to benefit from economies of scale as their management fee could generate a significant part of the fund manager’s profits.
Although future performance cannot be predicted accurately, our approach demonstrates that sector rotation can achieve above the norm long-term capital growth and when transaction costs and performance fees have been taken into account in our calculation, the NAV of our funds are still highly competitive compared to most of the top performing Hedge Funds.
It is also worth noting in table 3.1b that the fund has positive returns in 87% of the years from 1942 to 2017 for options 1, 2, 4 and 5, and 93% of the years for option 3.
We believe that the results obtained with our models are able to enhance the manager’s fund performance, return them extra performance fee and attract more capitals into their funds.
Table 2.1a: Results for the five different fee regimes (1942-2017)
| Fee regime options | S&P 500 TR CARG | Fund NAV CARG | Average Net Manager’s fee/year (%) | Average Performance fee/year (%) | Manager’s preference | Client’s preference | Winner |
| 1) 2% management fees | 9.14% | 12.93% | 1.20% | 0.00% | 5 | 2 | Client |
| 2) 2% management fees and 20% performance fee with hurdle | 9.14% | 11.61% | 2.40% | 1.20% | 2 | 4 | Manager |
| 3) 20% performance fee with hurdle | 9.14% | 13.61% | 1.42% | 1.42% | 4 | 1 | Client |
| 4) 2% management and 20% performance fees with hurdle and high water mark | 9.14% | 11.88% | 2.15% | 0.95% | 3 | 3 | Both |
| 5) 2% management and 20% performance fees on absolute returns | 9.14% | 10.33% | 3.58% | 2.38% | 1 | 5 | Manager |
Table 2.1b: Results for the five different fee regimes (1942-2017)
| Fee regime options | S&P 500 TR (+ve) Returns (%/+ve yrs) | Fund NAV (+ve) Returns (%/+ve yrs) | Fund NAV (+ve) Alpha (%/+ve yrs) | Performance fees (%/+ve yrs) |
| 1) 2% management fees | 77.46% | 85.92% | 56.34% | 0.00% |
| 2) 2% management fees and 20% performance fee with hurdle | 77.46% | 85.92% | 56.34% | 57.97% |
| 3) 20% performance fee with hurdle | 77.46% | 90.14% | 61.97% | 63.77% |
| 4) 2% management and 20% performance fees with hurdle and high water mark | 77.46% | 85.92% | 56.34% | 50.72% |
| 5) 2% management and 20% performance fees on absolute returns | 77.46% | 85.92% | 56.34% | 85.51% |
Table 2.2: Results for the five different fee regimes (2007-2017) based on a $10m fund at the beginning of the period.
| Fee regime options | S&P 500 TR CARG | Fund NAV CARG |
Average Net Manager’s Fee/year (%) | Net Manager’s Fees ($m) | Manager’s preference | Client’s preference | Winner |
| 1) 2% management fees | 7.70% | 6.29% | 1.20% | 1.73 | 4 | 2 | Client |
| 2) 2% management fees and 20% performance fee with hurdle | 7.70% | 5.55% | 2.01% | 2.36 | 2 | 4 | Manager |
| 3) 20% performance fee with hurdle | 7.70% | 7.40% | 0.92% | 0.93 | 5 | 1 | Client |
| 4) 2% management and 20% performance fees with hurdle and high water mark | 7.70% | 6.28% | 1.21% | 1.76 | 3 | 3 | Both |
| 5) 2% management and 20% performance fees on absolute returns | 7.70% | 4.79% | 2.79% | 3.81 | 1 | 5 | Manager |