Most UK funds charge a straightforward ongoing charges figure (OCF) each year, calculated as a simple percentage of assets under management. A smaller number of funds — historically more common among certain actively managed and alternative strategies — layer an additional performance fee on top, charged only when the fund achieves returns above a specified benchmark or hurdle. Understanding how performance fees are calculated, and the safeguards (or lack of them) built into their structure, is important for any investor considering a fund that uses one.
What a performance fee is
A performance fee is an additional charge, beyond the fund's standard annual management charge, paid to the fund manager when the fund's performance exceeds a defined threshold over a given measurement period (commonly a year). The rationale typically offered is that it aligns the manager's incentives with investors' interests — the manager earns more only when investors do well — though critics of the structure point out that it can also encourage a manager to take on additional risk in pursuit of a bonus, since the manager typically shares in the upside without symmetrically sharing in the downside.
Common performance fee structures
Hurdle rate
A hurdle rate is the minimum level of return the fund must achieve before any performance fee becomes payable at all. For example, a fund might need to return more than a stated benchmark, such as the FTSE All-Share Index, or a fixed percentage such as 5% a year, before a performance fee is triggered on the excess return above that hurdle.
High-water mark
A high-water mark is a mechanism intended to prevent a manager from being paid a performance fee twice for the same gain. It records the highest value the fund (or an investor's holding in it) has ever reached at the end of a previous measurement period, and requires the fund to recover any prior losses and exceed that previous peak before a new performance fee can be charged, even if the fund had a strong single year in between two weaker ones.
Fee sharing ratio
This is the percentage of the excess return, above the hurdle, that goes to the manager as the performance fee — commonly seen in a structure such as "20% of returns above the hurdle," though the specific figure varies considerably by fund and fund type.
A worked hypothetical example
Suppose a hypothetical fund charges a base annual management charge of 0.75%, plus a performance fee of 20% of any return above a 5% hurdle, measured annually, with a high-water mark in place.
| Year | Fund return (before fees) | Amount above 5% hurdle | Performance fee (20% of excess) | Notes |
|---|---|---|---|---|
| Year 1 | 12% | 7 percentage points | Charged on the 7-point excess | New high-water mark set at year-end value |
| Year 2 | -8% | None (below hurdle) | No performance fee | Value falls well below the high-water mark |
| Year 3 | 10% | None chargeable | No performance fee | Value has not yet recovered above the Year 1 high-water mark, so no fee is due despite a strong year |
| Year 4 | 9% | Depends on exact recovery level | Only charged on any excess above the high-water mark, not the 5% hurdle alone | Fee resumes only once the previous peak is exceeded |
This hypothetical illustrates why the high-water mark matters: without it, a fund could charge a performance fee in Year 3 purely because that single year exceeded the 5% hurdle, even though the investor's overall holding was still recovering from the Year 2 loss and had not yet returned to its previous peak value. These figures and this fund structure are illustrative only, constructed to explain the mechanism, and are not a real fund or a prediction of any actual returns.
How performance fees affect the total cost of holding a fund
A fund's headline OCF, as published in its Key Investor Information Document (KIID) or equivalent disclosure, does not always fully capture the potential cost of a performance fee, since by its nature a performance fee varies year to year and cannot be known in advance. Some funds disclose an average historical performance fee alongside the OCF, giving a rough sense of typical additional cost, though this is necessarily backward-looking and no guide to future charges. This means that comparing two funds purely on their published OCF can be misleading if one of them also carries a variable performance fee that, in a strong year, could add a meaningful additional cost on top.
Where performance fees are more commonly found
- Certain actively managed equity funds, particularly some specialist or alternative strategies.
- Hedge-fund-style or absolute return funds, where performance fee structures historically originated.
- Investment trusts, some of which have historically used performance fees, though many trusts have moved away from this structure in favour of simpler flat fees in recent years, partly in response to investor and industry pressure for greater fee transparency.
Performance fees are considerably less common among mainstream UK open-ended funds aimed at retail investors, and are essentially never found on passive index tracker funds, which by design aim only to replicate an index's return rather than to outperform anything.
Assessing whether a performance fee structure is reasonable
Questions worth considering
- Is there a high-water mark, and does it apply indefinitely or reset after a certain period (some structures reset the high-water mark after a number of years even if losses have not been recovered, which is generally viewed as less favourable to investors)?
- Is the hurdle rate a fixed percentage, or linked to a relevant market benchmark — and if fixed, is it set at a level that seems reasonably demanding relative to typical returns for that asset class?
- Is the performance fee calculated on the whole fund's gain, or on each individual investor's own gain based on when they invested (this can matter for investors who join partway through a strong or weak period)?
- How does the base annual management charge, before any performance fee, compare with similar funds that do not use a performance fee structure at all?
Regulatory and disclosure context
UK-authorised funds are required to disclose their charging structure clearly, including any performance fee mechanism, hurdle, and high-water mark provisions, within the fund's prospectus and Key Investor Information Document or equivalent disclosure document. The Financial Conduct Authority has, over recent years, placed increasing emphasis on fund charge transparency generally, including scrutiny of performance fee structures that could be seen as poor value or overly complex for retail investors to understand. This has contributed to a general industry trend toward simpler charging structures, though performance fees have not disappeared entirely from the market.
Performance fees within tax-efficient wrappers
Performance fees, like any fund charge, are deducted from the fund's assets before returns are attributed to investors, regardless of whether the fund is held directly, within a Stocks and Shares ISA, or within a SIPP. This means the fee itself is not affected by the tax wrapper chosen, but the wrapper does affect what happens to the return that remains after fees. Held within an ISA (current annual allowance £20,000) or a SIPP (annual allowance £60,000 or 100% of earnings if lower, tapered for high earners), any gain net of fees grows free of further UK income tax and capital gains tax. Held outside a wrapper, in a general investment account, gains above the £3,000 annual capital gains tax exempt amount would potentially be taxable at 18% or 24% depending on the investor's tax band, meaning the combined effect of a variable performance fee and ordinary capital gains tax could make an unwrapped, performance-fee-charging fund a comparatively costly combination in a strong year. This is one reason some investors prefer to hold funds with more variable or higher potential charges inside a tax-efficient wrapper where possible, though the specific right approach depends on individual circumstances and overall available allowances.
How performance fee crystallisation typically works
The point at which a performance fee is actually calculated and deducted from the fund (sometimes called "crystallisation") is usually a fixed date, most often the fund's annual accounting date, though some funds crystallise fees more frequently. Investors who buy into a fund partway through a performance measurement period, or who redeem their holding before the crystallisation date, may be subject to specific rules about how any accrued but not-yet-crystallised performance fee liability is handled — some fund structures accrue a provision for the estimated fee daily within the fund's published price, so that investors buying or selling mid-period are treated fairly relative to the fee likely to be charged at the next crystallisation date. This detail is set out in the fund's prospectus and is worth checking for any fund using a performance fee structure, since it can affect the price an investor actually pays or receives when dealing partway through a fee period.
Key takeaways
- A performance fee is an additional charge on top of a fund's standard annual management charge, payable when returns exceed a defined hurdle.
- A high-water mark is intended to prevent a manager being paid twice for the same gain, by requiring losses to be recovered above a previous peak before a new fee can be charged.
- Because performance fees vary year to year, they are harder to compare across funds than a simple flat OCF, and a fund's headline charge may understate potential total cost in a strong year.
- Performance fees are more commonly found in certain actively managed, alternative, or historically trust-based strategies, and are essentially absent from passive index tracker funds.
- Key questions to ask include whether a high-water mark exists and whether it resets, how the hurdle rate is set, and how the base charge compares with similar non-performance-fee funds.
- Fund charging structures, including performance fees, are disclosed in the prospectus and Key Investor Information Document — reading these directly is the most reliable way to understand a specific fund's actual charging mechanism.