Be it that actively managed funds have significantly higher fees than passively managed funds which simply track market benchmarks, the expectation of active funds have always been for them to beat the market. Yet, actively managed funds are in the midst of a long losing streak that began in 2008. Nobel laureate Eugene Fama and Kenneth French found that only about 2% of the 3,156 fund managers they examined had statistically significant evidence of skill. They also concluded that a portfolio of low-cost index funds is likely to perform about as well as a portfolio of the top 3% of actively managed funds.
Within this pool of funds, there exists a gamut of fee structures comprising various degrees of management and performance fees. It is my belief that there should be a distinct relationship between fees charged and expected fund performance, not unlike how one would expect a $100 steak to be pretty damn much better than a $20 one. Sadly, when it comes to funds, such a concept seems to be lacking – how much returns should one expect when paying Y fees? How should an investor evaluate a 0-20 fund pegged to the MSCI AC Asia Pacific ex Japan versus a 1-15 fund pegged to the Russell 2000? This will be expounded in the later part of this essay but first, we start with some simple concepts and ideas.
The significance of performance fees
Performance fees are payments made to a fund manager for generating positive returns and are calculated based on investment profits. Recall that active fund is expected to beat the market benchmark net of fees. Now, for a fund charging only performance fees, the amount of gross returns it would need to beat the market is increased by the amount of performance fees charged. In this regard, performance fees constitute the hurdle rate above the market return which prospective investors should expect when gross fund return is positive.
Required fund return = Market Return x (1 + Performance Fee Rate)
The significance of management fees
Management fees are periodic payments made to the fund’s investment advisor for both investment advisory services and administrative services. Unlike performance fees, management fees are calculated as a percentage of AUM and are chargeable whether or not the fund generates positive returns. Using a simple example of a fund charging only management fees, the amount of gross returns it would need to beat the market is increased by the amount of management fees charged. There are 2 vital differences from performances though; firstly, this is applicable in both bull and bear markets and secondly, the hurdle rate is a summation rather than a product.
Required fund return = Market Return + Management Fee Rate
Therefore, management fees represent the hurdle rate above market return under both negative and positive gross fund return scenarios. It is also a steeper hurdle rate than performance fees as it is based on asset under management.
Asymmetrical payoffs
The significance of performance and management fees in relation to expected returns in reality is, unfortunately, more complicated than depicted above. Funds usually employ a mixture of both management and performance fees in their fee structure, resulting in an asymmetrical payoff depending on whether returns are positive or negative. Therefore, some mathematical wizardry is necessary before we can equate fees with expected return. The full derivation can be found here and promises to be a laborious read for many.
Embarking on a little fact finding mission, we have gathered the data of some of the more commonly used benchmark indices in the region and their relevant statistics.
| Time Period | No. of Bull Years | No. of Bear Years | CAGR (%) | |
|---|---|---|---|---|
| MSCI AC Asia Pacific ex Japan | 1987-2014 | 17 | 10 | 5.71 |
| MSCI AC Asia ex Japan | 1987-2014 | 18 | 9 | 6.41 |
| MSCI AC Pacific ex Japan | 1969-2014 | 28 | 17 | 5.56 |
| S&P 500 | 1961-2014 | 47 | 17 | 7.21 |
| Russell 2000 | 1987-2014 | 19 | 8 | 8.53 |
Using these data and the equation, an investor can calculate the amount of gross returns he should expect from a fund for a given fee structure. In the interest of readability, I tabulate only the statistics for the MSCI AC Asia Pacific ex Japan and Russell 2000.
Expected fund gross returns with Russell 2000 benchmark
Expected fund gross returns with MSCI AC Asia Pacific ex Japan benchmark
Earlier, we raised the question of how should an investor evaluate a 0-20 fund pegged to the MSCI AC Asia Pacific ex Japan versus a 1-15 fund pegged to the Russell 2000? The verdict is out – he should demand a similar level of return for both (11.4% for the Russell 2000 fund and 11.5% for the MSCI AC Asia Pacific ex Japan fund). It seems peculiar that the expected gross returns for the MSCI AC Asia Pacific ex Japan fund are overall higher than that of the Russell 2000 fund even though the latter has had a higher CAGR of 8.53% versus the former’s 5.71%. In using the equation on a general basis, we take d and c to be equal to the respective benchmark’s data (number of bull and bear years). The Russell 2000, while having a higher benchmark return, has a significantly lower proportion of bear years. Therefore, returns during the proportionally higher number of bull years can afford a lower hurdle rate.
Final words
Comparisons aside, it is evident that the expected fund gross returns are substantially higher than the baseline benchmark returns. It seems to indicate that conventional wisdom, if it even exists at all, underestimate the hurdle rate required by funds to generate outperformance. Bearing in mind the assumptions and limitations in place, my main intention is to highlight explicit relationship between outperformance, fee structure and benchmark utilised which I believe has been sorely lacking hitherto. Perhaps, we have been overly-generous in our payments to fund managers. And perhaps, the underperformance of active funds is an inevitable result of that generousity.
