Case 016Fund economics, NAV and LP decisionsHard
An investor compares the Colvane Platform, which charges pass-through expenses of 6% plus a 20% performance fee, with a fund charging 2 and 20. At gross returns of 10%, 18% and 25%, which is cheaper?
1The situation
Colvane Platform is a multi-manager fund with dozens of trading pods. It charges no management fee. Instead it passes through its expenses to investors: portfolio manager payouts, salaries, data, technology and office, which last year came to 6% of assets. It then charges a 20% performance fee on returns after those expenses.
An endowment is comparing it with a single-manager fund that charges a 2% management fee and 20% of returns after that fee. Both managers expect similar gross returns before any fees or expenses. Assume performance fees are charged only on positive returns.
2Your task
At gross returns of 10%, 18% and 25%, which structure leaves the investor more, and what would Colvane have to deliver to justify its cost?
Quick check
At an 18% gross return, what does the investor net from Colvane?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
The 2 and 20 fund is cheaper at every gross return: the investor nets 6.4%, 12.8% and 18.4% against Colvane's 3.2%, 9.6% and 15.2%. Colvane's 6% of expenses is 4 points more than a 2% fee, and after the 20% performance fee that leaves a constant gap of 3.2 points. The gap never closes, so Colvane must earn about 4 points more gross return, or deliver the same return with much lower risk, to justify it.
Step 1How do you compute the net return under each structure?
Always in order: costs that come off the top, then the performance fee on what is left. For Colvane, net return is 0.8 times gross minus 6%; for the 2 and 20 fund it is 0.8 times gross minus 2%. At 18% gross, Colvane leaves 12% after expenses and takes 2.4 points of fee, netting 9.6%; the fund leaves 16% after its fee and takes 3.2 points, netting 12.8%. The fund charges more performance fee in rupees because it leaves more gain to charge on, and the investor is still better off.
| Gross return | Colvane: after 6% expenses | Colvane net | 2 and 20: after 2% fee | 2 and 20 net | Gap |
|---|---|---|---|---|---|
| 10% | 4.0% | 3.2% | 8.0% | 6.4% | 3.2 |
| 18% | 12.0% | 9.6% | 16.0% | 12.8% | 3.2 |
| 25% | 19.0% | 15.2% | 23.0% | 18.4% | 3.2 |
Step 2Why is the gap the same at every return?
Both structures share the same 20% performance fee, so the only difference is what comes off the top: 6% against 2%. Picture two restaurants with the same 20% service charge on the bill, one of which also adds a fixed Rs 600 cover charge where the other adds Rs 200. The extra 4 points come off before the performance fee, so the investor loses 4 points less the 20% of it the fee would have taken, 3.2 points, whatever the gross return. Below 6% gross the gap widens to as much as 4 points, because Colvane then earns no performance fee to share the pain.
Step 3Where does the 6% go, and why do platforms charge it?
Most of a platform's pass-through is portfolio manager pay, and that is where the structure bites. A platform pays each winning pod its share of profits even when losing pods drag the whole fund down, so investors fund payouts on gross winnings rather than net results, a cost called netting riskThe cost to investors when a multi-manager fund pays bonuses to winning teams while other teams lose, so total payouts exceed a share of the fund net profit.. The platform's argument is that this buys the best traders and tight risk control across many uncorrelated pods, which should mean higher gross returns and lower volatility than one manager can deliver.
Step 4So what must Colvane deliver?
Frame the answer as a hurdle, not a verdict. To match the fund's net return, Colvane needs gross returns 4 points higher, or the same net return with materially lower risk. If Colvane nets 9.6% with 4% volatility while the single manager nets 12.8% with 12% volatility, the platform delivers far more return per unit of risk and the endowment could hold more of it. So the allocator's job is to compare net returns and net volatility, not fee schedules. Say that the 6% is last year's figure and will move with pod payouts and headcount, so the investor should look at several years of pass-through history before committing.
Where candidates lose it
The common error is comparing 6% of expenses with a 2% fee and stopping at a 4 point gap, or charging the performance fee on gross returns before expenses. The fee comes after the pass-through, which is why the gap is 3.2 points and not 4.
The second is calling the platform too expensive and ending there. The interviewer wants the hurdle, 4 points of extra gross return or much lower risk, and the reason platforms can sometimes clear it.
What the interviewer asks next
- Colvane caps pass-through expenses at 4%. What is the gap now?
- How does netting risk show up in the expense ratio in a year when half the pods lose money?
- How would you compare the two on a risk-adjusted basis if Colvane's volatility is a third of the fund's?
Company names and figures are illustrative.