23rd March 2015

ValueEdge

Goh Tee Leng

Yeo Sui Chuan

Derivation of Fee-Returns Equivalence Formula

Legend
x
y
z
a1
a2
b
c
d

Explanation
Level of performance fees (i.e. x=20 if performance fees is 20%)
Level of management fees (i.e. Y=1 if management fees is 1%)
Geometric return of a benchmark (i.e. Z=10 if benchmark return is 10%)
Expected gross geometric return of the fund (i.e. a=20 if gross fund return
is 20%) in bull years when returns are positive
Expected gross geometric return of the fund (i.e. a=20 if gross fund return
is 20%) in bear years when returns are negative
Value of asset under management
Number of bull years experienced by the fund/benchmark
Number of bear years experienced by the fund/benchmark

When a fund incurs positive returns

Total fees = Management fees + Performance fees
This can be expressed as

100
100
100
Therefore, we can write fund return net of fees as
1
1

100
100
100
Divide by b to obtain returns in percentage

(1)

1
1

100
100
100
When a fund incurs negative returns
Total fees = Management fees
This can be expressed as

100
Therefore, we can write fund return net of fees as
2

100
Divide by b to obtain returns in percentage

(2)
2
100

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By combining (1) and (2), the geometric net return of a fund is expressed as
+

(1 +

1
1

2

) (1 +
) 1
100
100 100
100

As there are 2 unknowns in 1 equation (a1 and a2), we assume that a fund incurs zero returns
during a bear year (i.e a2 = 0) to arrive at
+

(1 +

1
1

) (1
) 1>
100
100 100
100
100

Variables d and c are fund-specific forward projections estimated based on investors discretion.
However, in using the equation on a general basis, we take d and c to be equal to the respective
benchmarks data (number of bull and bear years).
Comments
As mentioned, one assumption we make is that a fund will make zero gross returns (but also zero
gross losses) in a bear year. This might not be entirely realistic, but technical constraints
necessitate such an assumption. Furthermore, in the quest of expected fund returns, such an
assumption lends a degree of conservatism which is best expressed as such what is the
minimum gross return that a fund is expected to achieve in order to outperform its benchmark,
assuming that it never even incurs negative returns? In the vicissitudes of financial markets, it is
inevitable for a fund to experience negative returns from time to time. Positive returns during bull
years would have to be higher than the values derived from our equation to offset such losses.

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