Swedroe: Performance Fees Add Risk

October 20, 2017

A 2015 study of global pension assets from Towers Watson revealed that the 16 largest pension markets in the world increased their allocations to alternative asset classes from about 5% in 1995 to 20% in 2015.

The reasons for this increased allocation to alternative asset classes include higher forward-looking return expectations, better portfolio diversification and, in some cases, a better match with the pension fund’s liabilities. Alternative investments, however, can often come with performance fees that are in addition to the fund’s expense ratio.

Dirk Broeders, Arco van Oord and David Rijsbergen contribute to the literature on pension funds and performance-fee investments with their July 2017 study, “Does it Pay to Pay Performance Fees? Empirical Evidence from Dutch Pension Funds.”

They begin by noting that the annual performance fees paid by Dutch pension funds increased by 36% from €1.1 billion to €1.5 billion between 2012 and 2015.

Economically Rational

Paying performance fees could be economically rational if the investments that charge them enhance overall net performance by recovering their cost with superior returns or greater diversification benefits.

On the other hand, it’s well known that performance fees tend to create a skewed (call-option-like) incentive structure because the fund sponsor typically only benefits from positive returns but does not suffer from losses—creating the potential for incentivizing managers to take excessive risks in an attempt to generate high returns.

Broeders, van Oord and Rijsbergen examined three main questions:

  • Does paying performance fees contribute to higher net total returns or net excess returns?
  • For what type of gross return, excess return or total return, do pension funds primarily pay performance fees?
  • Do large pension funds and pension funds with more specialization in their investment portfolios pay less of a performance fee per basis point of gross excess return?


To answer these questions, they examined the investment returns, benchmarks and costs for 218 Dutch pension funds between 2012 and 2015. The assets under management of the funds in their dataset increased from approximately €853 billion in 2012 to €1.12 trillion in 2015.

On average, this amounts to 97.5% of the total assets under management for all Dutch pension funds during the sample period. Following is a summary of the authors’ findings:

  • After adjusting for risk, returns earned by pension funds that pay performance fees to asset managers are not significantly higher or lower than returns earned by pension funds that do not pay performance fees.
  • Performance fees primarily relate to gross excess returns for equities and hedge funds. Respectively, pension funds pay 2.1 and 30.5 basis points in performance fees for every 100 basis points of gross excess return. For private equity, performance fees primarily correspond to gross total return. Investment mandates for private equity thus appear more focused on absolute returns than on outperforming a benchmark.
  • Large and more specialized pension funds are able to realize more profitable mandates with their asset managers, possibly as a result of better negotiation power due to their large scale or higher level of expertise. For example, for the data sample’s larger pension funds, a tenfold increase in hedge fund investments correlates with a 5.5 basis point reduction in performance fees per 100 basis points in gross excess return. More specialized pension funds that increase their allocation to private equity by 1 percentage point pay 0.37 basis points less in fees per 100 basis points in gross excess return. For hedge funds, this reduction is 0.36 basis points.

Broeders, van Oord and Rijsbergen concluded: “We find no statistical evidence that paying fees for most asset classes adds or subtracts value.”

While there was no evidence of superior results, as mentioned above, performance fees do create a potential for greater risk-taking by the fund sponsor. Thus, the pension plans that paid them were accepting greater potential risks without having received any benefit in terms of superior returns.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


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