The perfect performance fee: Part 2

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There is no market standard for how a performance fee is constructed.  The end result is that not all performance fees are equal – some are strongly in favour of the manager.  In this commentary John Berry looks at reasons justifying why managed funds have performance fees and also speculates on future developments for such fees.

Wednesday, December 3rd 2014, 6:34AM 1 Comment

by Pathfinder Asset Management

The key elements of a performance fee are the hurdle,  share of excess returns and high water mark.  Please see part one of this commentary if you need a refresher on these terms and general discussion on how a performance fee operates.  This commentary addresses the question of why funds have performance fees and reviews 4 reasons commonly held out by the industry.

Reason #1: only post fee returns matter

On the face of it this seems entirely fair.  Investors only care about actual post fee returns – how large the fees are and how the performance fee is constructed just shouldn’t matter.

But in reality it does matter.  There is plenty of research showing that the size of manager fees can be inversely correlated to after fee performance.  Intuitively this would seem to make sense – if an investor gives up 20% of the upside but keeps all the downside you must squew the risk / return profile of a fund. 

For this reason I would argue that being concerned only with post fee returns as a justification for performance fees should be limited to absolute return and niche alternative strategy funds (i.e. long/short, market neutral etc).  For “conventional” actively managed equity funds investors should care about the quantum of fees charged as well as post fee returns.

Reason #2:  no performance fees would mean higher base management fees

This reason sounds entirely logical.  Fund managers are rational profit seeking businesses, not charities – if performance fees are lower then managers will need to charge higher base fees to make up the shortfall.  Or would they?

It is a struggle to find any evidence to support this.  However the argument is widely accepted – even the FMA has written “we expect the higher the base fee the lower the expected level of performance fee.”  In reality the opposite may be the case. 

The graph below plots the base management fee against the peformance fee for 25 actively managed equity funds (22 PIEs and 3 Australian unit trusts) from 13 managers.  If the performance fee justification is true (i.e. lower performance fees would lead to higher base fees) then you would expect the trend line to be downward sloping.   But the trend line goes the other way implying the higher the base management fee the higher the performance fee!

This does not support the argument that no perofrmance fees would mean higher base fees – in fact it implies the opposite!  (Note the bubbles with a number inside count how many funds fall on the same spot – there are 25 data points).

Reason #3:  performance fees align manager and investor interests

In a rising market the alignment is obvious.  The more money the investor makes, the more the manager makes – so it is a win / win.  But what about on the way down?  The investor has a loss, the manager has no loss – there is no alignment of interest.  The performance fee pay off is asymetric – on the way up you share the gain, on the way down you don’t share the pain!  This could be a poor alignment of interest.

There is a better way for fund managers to align interests with investors – managers should invest in their funds.  Below is a table of manager holdings in funds for 3  managers.  This information is freely available – look on companies.govt.nz and search “other registers” for a particular fund.  Read the related party notes to the latest financial statements and it will tell you how much related parties hold in the fund.  If there is no disclosure, then there are no related party fund holdings.

The numbers as a percentage of fund size do not look huge (ranging from 0.20% to 13.8% per fund).  But don’t be fooled, the lowest investment by a manager across its funds totals $750,000 while the highest is many millions.  That is an alignment of interest - mangers should eat their own cooking and invest in their funds. 

Financial advisers should ask managers how much they invest in their funds.  Easier still, the FMA should consider ways of making this (already public) information more accessible to investors.

Reason #4:  performance fees incentivise manager performance

This reason is very close to reason three (aligning manager and investor interests) – but it is not quite the same.  Incentivising and rewarding excellence in manager performance is simply encouraging high returns over pre-determined periods, it does not give any incentive around the smoothness of return outcomes.

Incentives to perform can be powerful.  Team Oracle was reported to receive a massive cash bonus if they won the Amercia's Cup – that is likely to have powered the team to never give up and to chase every possible way to go faster.  But incentives can also have unexpected outcomes – when parents encourage their rugby playing youngster to score tries with say a $5 per try incentive - but they are really incentivising the youngster to not pass the ball inside the 25 metre line.  That is an unintended outcome of the incentive.

Performance fees may also affect manager behaviour in unintended ways –

• if fund performance is just under the performance fee hurdle – it could be seen as an incentive to dial up risk and try and earn the performance fee
• if fund performance is well ahead of the hurdle – it could be seen as an incentive to take risk off the table and lock in gains.

Neither of these investment outcomes is intended, but they are rational human responses to the incentive on offer.  Whether in reality the manager responds to this incentive does not matter – what matters is that there is a perceived conflict of manager vs investor interests.

The incentive / disincentive debate is best illustrated with a little advertised suggestion from the FMA when it sought industry feedback on KiwiSaver performance fees in 2012.  The FMA suggested managers of default funds pay part of their fee back into the fund if they underperform a benchmark.  Industry was unimpressed by the thought of a “negative” performance fee.

One bank submitter said “such a fee structure could also encourage managers to invest client assets in an overly conservative manner.”  That is an interesting admission.  If a “negative” performance fee (manager pays fund) means the manager will invest in an overly conservative manner what does a “positive” performance fee (fund pays manger) incentivise?  If the flip side is true then “such a fee structure could also encourage managers to invest client assets in an overly aggressive manner.”  An incentive to perform can have unintended consequences…

What is the future of performance fees?

Performance fees are treasured by managers and (largely) tolerated by financial advisers and investors.  But they can be unreasonable and can hurt returns.

For several years now pressure has been mounting on fund managers to lower fees.  Base management fees are being squeezed down – performance fees should over time be feeling the same pressure.  But it will be a slower process with performance fees than for base fees (largely because the full cost of performance fees can be hidden through a combination of of non-standardised fee structures and poor disclosure to investors).

KiwiSaver, which is often the leader in funds management trends in New Zealand, may change this.  The KiwiSaver Act prescribes that fund manager fees must not be unreasonable (a novel idea!).  Based on the principle of reasonable fees, the FMA issued a handy guidance note on performance fees in KiwiSaver.  This contains several interesting guides such as:

• The performance fee hurdle should reflect the underlying risk and assets (i.e. cash benchmarks for equity funds are not a good idea)
• There should be detailed disclosure including a clear description of how the performance fee works
• The performance fee should have a cap (interestingly at least one fund manager has included a 2% cap on kiwisaver performance fees but funds outside kiwisaver have no performance fee cap).  The cap idea makes sense – the trust deed for every fund is required to set a cap to the base management fee  – why not the performance fee?

The FMA is making efforts to standardise and improve performance fee behaviour in kiwisaver.  May be this will wash over to funds outside kiwisaver, but most likely not.  As we will see in part three of this commentary, there are plenty of practices outside of kiwisaver that would violate the FMA’s performance fee guidance.  Investors and advisers need standardisation of performance fees, clearer disclosure and fairness in the way performance fees are structured.  For too long now performance fees have been allowed to hide in the shadows.

John Berry
Executive Director
Pathfinder Asset Management Limited

Disclosure of interest - Pathfinder is a fund manager that does not charge performance fees on its funds.  Seek advice - Pathfinder does not give financial advice - seek professional investment and tax advice before making investment decisions.

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz

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