Operational Alpha has become widely adopted as a buzzword in the investment industry that is widely understood to mean saving costs through administrative and operational efficiency. The term alpha in an investment context is also described as outperformance or edge and creating it means managing risk effectively.
The task of truly calculating operational alpha is an unenviable one, not least due to the downside risk from operational errors. Basis points saved in efficiency or squeezing the custodian can easily be lost on operational errors, and then some taking stakeholders into negative alpha territory!
One area worthy of focus is that of performance fee calculation – and errors! For many investment managers and those that might track them (e.g investors in mandates), tailored spreadsheets remain a widely utilised calculation method. Errors can be extremely expensive and when these errors are not caught early the costs compound at a rate of knots.
For many investors in managed funds or segregated managed accounts, accepting performance related or incentive fees has been part of a quid pro quo in exchange for lower management fees. For hedge funds, these fees have been part of the landscape since Paul Tudor Jones was a boy. There have also been numerous cases where fund managers have reduced their standard fixed management fees in exchange for a greater share of the upside and investors have been accepting of the trade-off. It’s worth noting that this isn’t solely a hedge fund issue either, many long only managers in equities – particularly small caps and bonds – use performance fees as well.
Performance fees can be mathematically complex and include such characteristics as high watermarks, benchmarks, audit holdbacks and even clawbacks. As such, the task of calculating the performance fees is not insignificant, especially when conducted on non-purposed software (aka spreadsheets).
During a well-executed fund setup phase, asset managers and administrators need to prepare fee models that include market benchmarks and high watermarks (prior high NAVs below which no performance fees are changed) adjusted for distributions where necessary.
Often the process consists of multiple input and checker tests, including senior review from highly experienced accountancy professionals at the auditor. Looking back over errors that have occurred, it is clear that not all set-up phases are created equally. And some set-up phases may not have benefitted from some of these robust checks and balances.
The highwater mark is also a challenge for funds. They are not reset often, meaning that someone has to be fully cognisant when the unit price or account value exceeds the highest prior NAV. Worryingly, in busy cost-pressured environments, these tasks can get overlooked and the size of the error can compound quickly, especially with daily priced funds.
Even if a smart operations professional thinks there might be an issue with the performance fee calculation, the next logical step can cause further confusion. What does the investment management agreement, PDS or constitution say? At this point the operations person can be confounded by complex legalese or language that is so broad it could include a wide range of methodologies.
I see performance fee wording that spans multiple pages in offshore fund offering documents as they describe every detail with accuracy, however, readers might need a cold towel over their heads to get through it. As for PDS’, performance fees are usually covered off in a paragraph, maybe two. Whilst the noble goal of keeping it simple for investors is laudable – it can also mean it is not precise. Certain parts of the calculation might be open to interpretation, which makes implementing the calculation in Excel highly challenging.
In short, the legal wording can further delay resolution of the issues. An industry veteran with decades of experience in fund operations informed me that not all auditors will re-check the veracity of the fee calculation methodology, instead, merely checking if it remains the same as last year. If that is the case, it’s not difficult to see how methodologies with deeply buried flaws pass muster.
That said, many checks and balances remain in place and the vast majority of performance fees are calculated correctly. However, those that have been involved in performance fee errors know that resolution can take an excruciating amount of time, particularly from busy senior management and executives.
Responsibility for the calculation lies with the RE and we are seeing RE’s implementing software to more closely track these calculations, which is a hugely positive development. More widely, specialist software including performance fee logic is becoming increasingly utilised.
For those involved in the calculations, multi-period examples as part of the training are also very helpful. Additionally, some senior operations and accountancy veterans are becoming performance fee trouble-shooters and are brought in to assess the calculations independent to the audit process.
Operational alpha is a laudable goal, particularly where it takes into account reduction of existing risks as well as costs. However, the rewards for doing complex things correctly cannot be underestimated as failure to do so can take funds into negative alpha quickly.