By Hysni Kaso
Appeared in Investment Week, 29 September 2010
City veteran Terry Smith, who will shortly launch his own fund management group, has hit out at performance fees which he argues do nothing more than destroy investor returns.
Smith, the Tullett Prebon CEO and deputy chairman of Collins Stewart, says a good example of how performance fees can erode returns for underlying investors can be seen by studying Warren Buffett’s Berkshire Hathaway vehicle.
He said a $1,000 investment in Berkshire shares when Buffett began running it in 1965 would have been worth $4.3m at the end of last year.
However, Smith says if Buffett had set up Berkshire as a hedge fund and charged 2% of the value of the funds as an annual fee plus 20% of any gains, $4m of the return would belong to him as manager and only about $300,000 would have been returned to investors.
"Two and twenty is the standard fee formula for the hedge fund industry. It is unsupportable," Smith says.
"I am not so much shocked as flabbergasted by the number of people who do not realise the impact of these performance fee structures.
"Such a structure clearly led many fund managers to gear up their funds as much as the credit bubble allowed and place bets which many attendees at Las Vegas would regard as outrageous, knowing that they had little or no downside and 20% plus of the upside.
"In a preview of the charging structure for his new Fundsmith venture, Smith says all performance fees are untenable.
"Two and twenty does not work. That does not mean that 1.5% and 15% is OK, or even 1% and 10%," he adds."
Performance fees do not work. They extract too much of the return and encourage risky behaviour.
"The only way to focus your fund manager on performance without gifting him or her most of your returns is to ensure they invest a major portion of their net worth alongside you in the fund and on exactly the same terms."