Performance fees is a concept I have never really understood; that I need to pay extra to my fund manager because he or she did his or her job seems a bit bizarre.
Yet this idea of performance fees, once the preserve of hedge fund managers, is all the rage in the unit trust industry.
The sales pitch is that the fund manager is sharing some of the performance risk with the client; that he or she will get paid only if he or she outperforms the benchmark.
In his paper ‘Whose Money Is It Anyway”, Rob Rusconi (the actuary who has built a reputation for questioning industry fees) says there are several issues with performance fees, not least the setting of the benchmark that the fund manager has to achieve to receive the fee.
Rusconi argues that often this benchmark is too easy to obtain and that performance fees reward luck as much as skill, especially if the benchmark is inflation plus a fixed target.
However, Johan Schreuder of Investec Asset Management argues that if properly managed, performance fees can be an advantage to investors.
A normal unit trust would charge a fixed annual fee of 1.5%, which is paid even if the fund manager is not performing. A performance-based fund manager charges below 1% (usually closer to 0.7%), unless he or she outperforms the benchmark.
Schreuder says this fixed fee mostly goes to administration costs rather than the fund manager, so for the fund manager to make money, he or she must deliver.
A performance-based fund manager with an index benchmark has to outperform significantly before he or she earns the flat fee earned automatically by a flat-fee manager.
For example, John Biccard, who manages the Investec Value Fund and who receives a performance fee of 20% of the outperformance, would have to deliver performance (alpha) of 3.5% above the index before his fund would earn the 1.5% fixed fee charged by his colleagues.
Schreuder says the problem is not performance fees per se, but rather how these fees are calculated and whether the client understands what he or she will be paying for.
Although the Collective Investment Schemes Control Act requires fund managers to fully disclose performance fees, the jargon is so complicated it is almost impossible to understand.
Consider some of these choice phrases: fee hurdle, sharing rate, rolling or cumulative measurement period, high-water marks with fee accruals suspended or refunded.
Geoff Blount of Cannon Asset Managers believes that the complexity in the industry allows some fund managers to purposefully hide their methods behind smoke and mirrors.
Fortunately, now that funds are forced to disclose their total expense ratios (TERs) , clients are getting a better idea of what performance fees are costing them. When investing in a performance-based fund, make sure you are keeping track of the TERs and whether they really reflect outperformance.
If you do invest in a fund with a performance fee, these are the questions you need to ask:
What are your minimum and maximum fees?
Some funds may charge a minimum fee of 0% or they may charge as much as 1%, so you need to know what you are paying for underperformance. Schreuder says the maximum fee is just as important. For example, the Investec Value Fund has a maximum fee of 4%, so even if the fund completely shoots the lights out, upside is limited. As an investor, you do not want to discover that the TER is running over 5%, for example.
Are performance fees charged net of costs?
A fund manager should earn fees only if he or she has outperformed after costs have been deducted.
What is your hurdle rate/benchmark?
This is the return the fund must achieve before it can start earning performance fees. As Rusconi points out, often the benchmark/hurdle rate is not aligned to the fund’s underlying investments. ‘Most benchmarks expressed as inflation plus a fixed target fall into this category (rewarding luck as much or more than skill), generating much higher performance fees in strong equity and bond markets,” says Rusconi. These benchmarks are usually found in absolute/real return funds. Rusconi argues that a hurdle rate should be based on the index performance of the asset class the fund is invested in.
What is your measurement period?
Rolling-period measurements have been criticised as rewarding past behaviour at the expense of new investors. For example, a manager who measures his or her performance over a two-year rolling period may have had a good 18 months, but is now underperforming. However, because of the past performance, the TER is sitting at 3% or 4% and all new investors are now paying for performance they have not enjoyed. Blount says a rolling period also forgives past poor performance and investors often pay simply for the recovery from bad performance.
For example, in 2008 few fund managers beat their benchmarks, but in 2009 they were more successful, even though they were only recovering their losses. As the rolling benchmark moves out of 2008, so they start to earn fees for ‘outperformance” in 2009, even though their total performance in the past 24 months has been flat relative to their index. Both Blount and Schreuder argue that a fund should earn fees only on performances delivered today.
Do you have a high-water mark or clawback fee?
Some fund managers, such as Cannon Asset Managers, use highwater marks to ensure that clients are not paying a performance fee just for a recovery. A high-water mark is where the fund manager has to recover his or her losses relative to their benchmark before he or she can earn performance fees. So if they underperformed their benchmark by 10% last year, they first have to outperform the benchmark (or deliver alpha) by 10% before performance fees can be charged. In this way the investor is paying only for outperformance in the long term.
Incredibly, Blount says some asset managers have questioned the logic of Cannon Asset Managers’ adoption of a high-water mark as ‘it is not as effective at extracting fees from clients”. Investec Value Fund follows a clawback-fee approach. Schreuder says that performance fees are calculated daily. Fees are levied when the fund outperforms, but when the fund underperforms, the performance fee is paid to investors. Although calculated daily, the net profit/loss is charged or paid back annually to clients.
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