Does it pay to pay performance fees?

Pension funds pay performance fees for active investment strategies and alternative asset classes such as hedge funds and private equity, the idea is that performance fees incentivise asset managers to outperform a benchmark.

A new study by Dirk Broeders, David Rijsbergen and Arco van Oord, from De Nederlandsche Bank, relates performance fees to investment performance. The study, Does it pay to pay performance fees, finds no statistical evidence that returns of pension funds that pay performance fees to asset managers for active investing are significantly higher or lower than the returns of pension funds that do not pay performance fees. This is true for most asset classes and robust if we correct for risk. We also document that large and more specialized pension funds pay less performance fees for a given level of excess return in alternative asset classes such as hedge funds and private equity.

The paper finds that large and specialised pension funds are able to realise more profitable mandates with asset managers. This is possibly the result of better negotiation power due to their large scale or high level of expertise.

Pension funds pay high performance fees for private equity and hedge funds

In 2017, 218 Dutch pension funds together paid EUR2 billion in performance fees to asset managers. To put this in perspective, these pension funds paid EUR 30 billion in retirement benefits in the same year.

The present value of performance fees represents the transfer of a significant fraction of the pension fund’s wealth from beneficiaries to asset managers. Performance fees vary across asset classes, with high fees typically being paid for private equity and hedge funds.

Between 2012 and 2017, pension funds paid on average 76 basis points per year of the assets under management (AUM) in performance fees for private equity. The pension funds in the 90^thpercentile, however, pay more than 235 basis points in performance fees for private equity.

For hedge funds the mean performance fee is 83 basis points of AUM, and top 10 per cent of pension funds pay 176 basis points or more.

To put this in perspective, the mean performance fee across time and pension funds for equities is 2 basis points and for fixed income it is as low as 0.5 basis point. The researchers also document net excess returns. The mean net excess return for private equity is 76 basis points, while the mean net excess return for hedge funds is -45 basis points. The mean net excess return for equities is 37 basis points and for fixed income it is 20 basis points. Net excess returns are defined as total returns less all investment costs (including performance fees) and benchmark returns. The benchmark returns are self-reported by the pension funds.

Size and specialisation matter

Our study shows that large and specialised pension funds, on average, pay more performance fees.They also find, however, that large pension funds pay less performance fees for the same level of excess return for hedge funds.

Pension funds specialising in private equity enjoy the same benefit, because these pension funds pay a smaller proportion of the excess returns in private equity to asset managers. So it seems that large and specialised pension funds are able to negotiate better terms with asset managers than smaller and less specialised pension funds. This may be because their size or expertise gives them more negotiating power. Large pension funds might also be more interesting for asset managers to have as clients because of reputational reasons.

Performance fees are less relevant for net returns

Active asset management is an important mechanism for price discovery in financial markets. Performance fees by construction are only paid if the asset manager delivers outperformance.

We compared the group of pension funds that pay performance fees, with the group that do not pay performance fees. We find that the net returns of the first group are not significantly different from the second group. This applies to most asset classes.

For access to the full paper click here