Management fees and Volatility

CFA Level III Portfolio Management
#1

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Which of the following fee structures most likely decreases the volatility of a portfolio’s net returns?

  1. A.Incentive fees only
  2. B.Management fees only
  3. C.Neither incentive fees nor management fees

Solution

A is correct. Because incentive fees are fees charged as a percentage of returns (reducing net gains in positive months and reducing net losses in negative months), its use lowers the standard deviation of realized returns. Charging a management fee (a fixed percentage based on assets) lowers the level of realized return without affecting the standard deviation of the return series.

How do management fees not reduce the volatility of net returns? Management fees would reduce the value of net returns around a mean, no?

#2

Is it because mgmt. fees are a constant % of AUM, so my avg. return and all my other returns are reduced by same amount, which means distance from the mean stays the same as it would for gross returns, which means my standard deviation comparing gross returns and returns net of fees would stay the same?

BUT with performance-based fees that are not symmetrical (thinking hurdle). Then your mean net return is not reduced by same amount as large positive net returns, reducing upside deviation, also reducing overall standard deviation?

#3

It is just the maths. My algerbra is not quite up to showing it easily.

5 returns 10%, 8%, -5%, 3%, 15%

2% management fee

5 returns 2% less : 8%, 6%, -7%, 1%, 13%

In both cases std deviation = 6.79%

Taking a fixed amount “2%” away from each value will not adjust chnage the standard deviation.

1 Like
#4

Thank you!