When I’m asked what to look out for before investing in a fund, most people expect the answer to focus on past performance, fees, or the fund manager’s reputation.
Those things do matter, but there’s another area that’s often overlooked, and in many cases far more important than investors realise, and that is the fund’s benchmark.
A benchmark is usually presented as a simple reference point, something a fund is measured against to determine whether it has performed well.
In reality, it does much more than that. It sets the hurdle a manager needs to beat, shapes how performance is framed, and in many cases, determines whether a manager earns performance fees.
That last point is where things start to matter.
Why investment benchmarks matter more than most investors realise
Many active funds charge a base management fee, often around 1 per cent, and then a performance fee, typically 10 per cent to 20 per cent of returns above a benchmark. On the surface, that sounds reasonable. If a manager delivers strong results, they get paid more. If they don’t, they don’t.
But this structure only works as intended if the benchmark itself is appropriate.
How benchmarks influence portfolio performance
In practice, one of the most common issues in funds management is the use of benchmarks that are set too low or that don’t reflect the level of risk being taken. This can create a situation where investors end up paying performance fees for returns that are, at best, ordinary for the underlying strategy.
Take a simple example.
Imagine a private equity fund that charges a 1 per cent management fee and a 15 per cent performance fee above a benchmark of 5 per cent. If that fund delivers 10 per cent net of management fees, which is broadly in line with long-term sharemarket returns, the manager earns the base 1 per cent plus 15 per cent of the 5 per cent return above the benchmark. That adds another 0.75 per cent in performance fees, taking total fees to 1.75 per cent per year and bringing the investor’s returns down to 9.25 per cent.
A 10 per cent return might sound strong in isolation, but for an equity-like strategy, it is not particularly exceptional, especially when investors are taking on illiquidity and concentration risk. Yet, the manager is still earning performance fees as if they have delivered meaningful outperformance.
In effect, the investor is paying extra for a result that could have been achieved through a low-cost index exchange-traded fund simply because the benchmark was set at a level that made average performance look like outperformance.
The problem with comparing investments to the wrong benchmark
A similar issue arises in private debt, where benchmarks are often set even lower.
It’s not uncommon to see private debt and credit funds charging a 1 per cent management fee and a 15 per cent performance fee above a CPI-linked benchmark. At first glance, CPI might seem like a reasonable hurdle, as it reflects inflation. But private debt is not a low-risk strategy. It involves lending to companies, often with credit risk, liquidity constraints, and exposure to economic cycles.
Comparing that to CPI sets the bar far too low.
It means that a manager can earn performance fees simply by taking on credit risk and delivering returns that are modest for that level of risk. A more appropriate benchmark would likely be a corporate bond index, or something that reflects the yield and risk profile of comparable credit exposures. But setting a lower benchmark makes it easier to generate “outperformance” and, therefore, easier to justify higher fees.
This is not always done with bad intent. In many cases, it reflects industry convention or the desire to present returns in a way that resonates with investors. But the outcome is the same. Investors are left with a distorted view of what they are actually getting.
The worst version of this is where performance hurdles effectively reset each year because the fund doesn’t apply a high watermark.
A high watermark ensures that a manager only earns performance fees after recovering any prior losses. Without it, a manager can generate strong returns one year, suffer losses the next, and still charge performance fees again as soon as returns move back above the benchmark, even if investors are still below their previous peak.
This creates a situation in which investors can be charged performance fees multiple times for the same underlying returns, yet never actually be ahead on a cumulative basis.
Over time, inappropriate benchmarks can have a meaningful impact on net returns.
An extra 0.5 per cent to 1 per cent in fees each year may not sound significant, but compounded over a decade or longer, it can reduce an investor’s balance by 10 per cent or more. And unlike market movements, which are unpredictable, this drag is entirely avoidable.
What investors should look for beyond headline returns
For investors, the practical takeaway is simple, even if the industry dynamics behind it are not.
Before investing in a fund, it’s worth asking what the benchmark is, whether it aligns with the strategy, and whether it represents a fair hurdle for the level of risk being taken.
Most importantly, investors should be wary of situations in which outperformance seems too easy.
If a fund consistently beats its benchmark by a wide margin, the question is not just whether the manager is highly skilled, but whether the benchmark itself is set at the right level.
Performance will always be the headline number that draws attention. But the benchmark determines how that performance is judged. And in many cases, that’s where the real story lies.
This article was originally published as an opinion piece for Australian Financial Review – Your fund manager may be earning performance fees for ordinary results (12 May 2026).
