The perfect performance fee (part 3)

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In the third part of its series on performance fees Pathfinder Asset Management reviews practical examples of how performance fees are calculated and disclosed by fund managers.  This involves a look at aspects of five performance fees for products currently available in the market.

Tuesday, February 10th 2015, 6:26PM 1 Comment

by Pathfinder Asset Management

Part one of this series was an overview of how performance fees work, and part two challenged industry reasons for why we need them.  Here we look at different fee structures and ask whether they are fair to investors.  

The intention is to highlight practices (not individual managers) so an effort has been made to ensure managers cannot be identified.  For example paragraph two below does not use real NAV numbers and in para 4 below the equity benchmark has been changed so the fund cannot be identified.  Each example is based on a real performance fee - these are not made up.  As an investor or adviser do you rate the practices below as fair?

1.  Using cash hurdles for equity funds
Investors often accept  the idea that an outperforming fund manager should be paid a performance fee.  If the manager delivers a truly outstanding return, then they should share the rewards with investors.  If you’ve invested in a fund where the manager outperforms by 2% then no problem paying them extra - they have earned it.  Or have they? 

How about if the out-performance was an international share fund beating the NZ cash rate (OCR) plus 5%?  NZ cash rate plus 5% is currently 8.5%.  In 2014 that was not a huge hurdle as world equity markets were up 11% in NZ dollar terms.  How would you feel about the international equity manager beating cash + 5% but failing to beat the MSCI World (in both NZD hedged and unhedged terms)?  How can a manager fail to beat the market but still collect a performance fee?  Is that fair to investors?  Should the hurdle for a performance fee not have some relevance to the asset class invested in?

2. The “Claytons” high water mark (the high water mark you have when you don’t have a high water mark…)
The idea of a high water mark is that a manager does not earn a performance fee where the fund NAV is below the level when the last performance fee was paid – otherwise the manager can be paid for the same performance twice.  This function of a high water mark is consistently understood across the industry - for example one manager describes it in their investment statement:

“A high water mark ensures that we must exceed the highest previous portfolio valuation before receiving any performance fee.  This means that we cannot receive a benefit more than once for the same performance.”

However another manager takes a different view on high water marks.  The illustration below shows a performance fee paid at the end of 2012 when the fund unit price was 100 – this sets the high water mark (i.e. a performance fee should not again be earned unless the unit price is above 100).  Through 2013 the fund loses money (unit price down to 50, no performance fee paid).  In 2014 the unit price recovers to the high water mark (100) and beyond (to 110).  

Given the high water mark is at 100, any reasonable investor would expect that the new performance fee is only paid on the increment from 100 to 110.  Anything else would mean that the manager has been paid twice for the same performance.  But no, this performance fee is structured to pay the manager on the increase from 50 to 110.  There is “double dipping” on returns already paid for, despite the high water mark.

How can a manager do this?  Is it an accident?  Financial alchemy?  No, it is clever legal drafting.  Their performance fee cannot be “paid” unless the unit price exceeds the high water mark – but the performance fee can “accrue” below the high water mark.  Despite being technically disclosed in offer documents this is contrary to how investors understand high water marks (and could be seen as misleading).

Investors want a performance fee structure that encourages the manager to take the unit price to new highs.   By contrast, this performance fee is paid if the unit price goes down and then back up to the previous level.  The investor wants positive returns while the fund manager could be satisfied with unit price volatility.   Is that fair?

3.  Layering performance fees on performance fees
Most (but not all) PIE funds that invest in international equities are fund of fund structures.  The NZ manager hands investor money over to an offshore manager, perceiving that they have the expertise to beat the market.  The international manager will invariably charge a performance fee for outperforming its benchmark.  How do you feel about the NZ manager than charging a further performance fee for the offshore manager’s out-performance?

This “layering” means we have a performance fee charged on top of a performance fee.  If the offshore manager takes 20% of out-performance and the NZ manager takes a further 10% of the remaining out-performance, a good chunk of the out-performance has just been syphoned off.  In this example the investor actually pays a performance fee of nearly 30%, being 1 – (0.8 x 0.9), which is quite different to expectations.

While it looks bad at first glance, this is not necessarily a problem for investors as long as it is disclosed properly.  Unfortunately that’s where we come unstuck –  it is unlikely investors understand the full impact of the layered performance fee structure.  Here is how the offer documents of four New Zealand managers (whose funds include investments in international equity funds with performance fees) deal with disclosure:

• One manager makes no reference to the fact that the offshore funds may charge fees (let alone performance fees). 
• Two managers mention that the underlying offshore managers will charge fees, but there is no explicit mention of performance fees. 
• One manager mentions performance fees being charged by the offshore manager (but gives no indication of the quantum of performance fee charged offshore or the impact this has on investor net returns).

In short, the disclosure of “layered” performance fees for fund of fund structures in New Zealand is inadequate.  The cost burden to investors is not explained. What looks like a 10% fee could be 30%.  Will the new PDS disclosure regime to be implemented over the next 2 years change this?

4.  Puzzling equity hurdles
The cash hurdle for equity funds (example 1 above) is unfair to investors.  A variation on this is to have an equity hurdle for an equity fund – but to have a total mis-match between the risk in the actual equity portfolio and the risk in the benchmark.  What we are talking about is akin to choosing the NZX50 as your performance fee hurdle when you are a global equity fund – there is no relevance with this hurdle.

One international share fund uses such an irrelevant equity benchmark for calculating performance fees.  They have underperformed in recent years so no performance fee has been paid – but that is not the point.  The point is that the calculation seems unfair to investors.

5.  Performance fee calculations using pre-fee returns
We expect performance fees to be calculated on fund returns after fees but before tax.  This calculation basis seems sensible and is consistent across managers.  So it’s unusual that one manager appears to use fund returns before fees and before tax for performance fee calculations.  There may be no ill-intent in using pre-fee returns in the performance fee formula – but why deviate from standard market practice? 

Without seeing the manager’s actual performance fee calculations it is impossible to know if gross returns favours the manager or the investor.  It seems likely to favour the managers as the performance fee is calculated off a larger (gross) return.  In an industry where we try and build trust, deviating from accepted norms on fee calculations is questionable. It also makes it harder to understand and compare products.

What does this mean for financial advisers?
Advisers need to be aware that there is no standard way to calculate performance fees.  Clear disclosure by fund managers is critical – but sometimes “technically compliant” disclosure to investors can still be misleading and deliver a performance fee that is unfair. 

Advisers need to remain vigilant with performance fees – ask tough questions and be direct.  Ask for worked examples.  It is your job to understand how your client’s money is invested and the fee burden your clients face.  Performance fees may be paid where the manager underperforms.  Or where returns are negative.  Or may be paid twice for the same performance.  It is the job of an adviser to identify these cases. 

Next month is the final part in this performance fee series. We will finish on a positive note looking at some fees that have been constructed or disclosed with investor interests in mind.  We will also look at the influences on fund managers and how these may force changes to performance fees.  But ultimately things won’t improve unless investors, advisers and the regulator demand it.

Disclosure of interest - Pathfinder is a fund manager and 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

Tags: Pathfinder Asset Management Performance fees

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