There is such a thing as a good performance fee
In the final instalment of this four part series on performance fees John Berry highlights positive examples of performance fee calculations and disclosure. He also considers how performance fees could develop in the future.
Thursday, March 5th 2015, 11:59AM
by Pathfinder Asset Management
In this series we have looked at how performance fees work, how the industry justifies using them and some questionable examples of performance fee structures. This final commentary recognises features of some performance fees that have investors' interests in mind. This is not an endorsement of any particular manager, their overall fee structure or the use of performance fees generally. It is simply recognising examples of performance fee features that are positive for investors.
Researching this article has involved reading non-KiwiSaver offer documents for 25 New Zealand-based fund managers (of which 19 charge performance fees in at least one fund) as well as offer documents for 10 KiwiSaver funds.
1. A performance fee cap
In 2012 the FMA issued KiwiSaver fund guidance encouraging managers to cap their performance fees. In fact the FMA goes as far as to say they “expect to see an annual cap on the performance fee in almost all circumstances.” Such caps can serve to limit the inequity of a cash benchmark used for growth assets and deliver more certainty to investors about potential fund costs.
So how has the FMA’s encouragement played out in practice? A review of 10 KiwiSaver growth / aggressive fund investment statements revealed performance fees charged by three. Of these three funds only Fisher Funds applies a performance fee cap (of 2%).
A cap makes sense – the trust deed for every fund is required to set a cap to the base management fee – why not also to the performance fee? (Note: a cap of 2% and manager share of 10% means the manager needs to return the performance fee hurdle plus a full 20% to hit the cap. This is not onerous for fund managers as it is rare a manager will achieve the hurdle plus 2,000 bps – for this reason it is hard to comprehend why more KiwiSaver managers have not followed Fisher Funds and introduced a cap).
It is worth noting that while only three of the 10 KiwiSaver funds directly charged performance fees, a further six disclosed that there were likely to be performance fees in the underlying funds invested in. Only one of the 10 growth / aggressive KiwiSaver funds has no performance fee in the New Zealand fund or in the underlying funds.
Although caps are encouraged by the FMA within KiwiSaver schemes, investors would probably appreciate caps being implemented in non-KiwiSaver funds as well. Outside of KiwiSaver Harbour Asset Management have a performance fee cap on their Australasian equity funds. The cap is set at a sensible 0.90%. This appears to be the sole example of a non-KiwiSaver performance fee cap – investors and advisers should push other managers to adopt a cap….. (Note: a cap of 0.90% and manager share of 10% means the manager needs to return the performance fee hurdle plus 9,000 bps to hit the cap).
2. Growth benchmark (plus a margin) for growth assets
For growth funds, a performance fee that reflects the underlying assets is preferable. This means for a New Zealand equity fund, the NZX50 is a fairer hurdle than the OCR or a fixed percentage (like 8% p.a.).
Active managers should show confidence in their ability to add alpha by not only choosing a growth based benchmark for performance fee calculations, but also requiring fund returns to beat that benchmark by a margin (for example NZX50 plus 2%).
Of the 25 fund managers reviewed 19 have performance fees in growth funds. Of these 19 only three have performance fees calculated off an equity benchmark plus a margin. Their use of a growth benchmark plus a margin for growth assets is fairer to investors. These funds are Harbour’s Australasian Equity Fund and Australasian Equity Focus Fund, Mint’s Active Equity Trust and Real Estate Investment Trust and Nikko’s Australasian Small Companies Fund. If only the list was longer…
3. Managers who give back
Many investors believe performance fees would be fine if the manager paid back into the fund when there is underperformance. The idea is unlikely to get much traction – however one fund manager has attempted to implement this structure. NZ Funds Management charges a performance fee on five of its funds where 10% is paid to the manager for returns above an 8% hurdle. If in the following year the fund underperforms the 8% hurdle then the manager repays part (or all) of the prior year performance fee.
This example of returning a performance fee for underperformance is unique in the New Zealand market. It probably won’t completely make up for losses (because it is limited to the extent of the performance fee paid in the immediately prior year) but it is a positive signal from the manager. Although they do not use a growth benchmark, their “pay back” feature should be encouraged.
4. Managers who scrap their performance fees
The long term trend is likely to be for lower performance fee charges, capped performance fees or no performance fee at all. This will come about through regulatory push, investor awareness and clear disclosure allowing unambiguous fee comparisons.
So congratulations to managers who recognise these changes coming and have already taken the plunge by scrapping their performance fees. In this category are ANZ and Elevation Capital (hopefully there are also others).
5. Positive absolute and relative returns
Common sense would tell us that a manager should only earn a performance fee if returns over that year are positive. But this is not always the case. Some performance fees are calculated and paid over shorter periods while other performance fees have no high water mark (or a high water reset). It is not illegal (but is unfair) for a manager to charge a performance fee where the return is better than the market but still negative in absolute terms.
So well done Mint Asset Management for making it very clear they are only paid if they beat the market and make positive returns. Their Investment Statement says performance fees are only paid on a fund where the return “is greater than zero, exceeds its Performance Target and is above the High Water Mark”. There is no room for ambiguity here – it is clear the performance fee can only be paid where investors have made money (absolute return) and the fund has beaten the NZX50 plus 3% (relative return).
Some tricky performance fee issues
There are a couple of fundamental issues with performance fees arising from the use of managed funds - entities where investors can “pool” their capital and invest together. Investors can come and go at any time through unit applications and redemptions. But this creates issues of fairness. For completeness these issues are summarised briefly below – there isn’t space to cover these off in detail:
Fair to new investors?: Imagine a fund where the performance fee is calculated on returns exceeding 10% and over the first six months of the year the fund returns 12%. New investors may be attracted to this successful fund without realising they are paying the performance fee from day one.
Yes, although the hurdle is 10% that does not mean new investors earn 10% before the performance fee kicks in – for them it is charged from the outset. This is very unfair to new investors.
Unfair to managers? Where a manager is well below their high water mark, new investors joining benefit from the high water so may not be charged a performance fee despite fund outperformance. (One manager has tried to deal with this issue by having the ability to charge the performance fee only to new investors and disregard the high water mark. It would be interesting to see how this is applied in practice and how well it is understood by investors).
Performance fees: where too from here?
Fund managers compete in an evolving market – the pressures for change are set to continue for some years yet. There is change forced by regulation – seeking clearer and standardised disclosure.
There are investor demands for less complexity, more product transparency and lower fees. There are global economic demands of a low interest rate and low return world. There are changes from new technology and the disintermediation of roles. What will happen to performance fees in this changing world? Do they still have their place?
Performance fees are not going away any time soon. But they are changing – the manager share is generally lower than when performance fees were first conceived (from 20% down to 10%). Performance fee hurdles should standardise (growth hurdles for growth assets). More managers will cap or drop performance fees altogether.
Competitive pressures are squeezing base management fees down – over time performance fees should react to the same pressure. But the biggest change is coming from regulatory pressure.
At the moment performance fee calculations are often hard to understand and inconsistent across the market. Without doubt better disclosure and standardisation is coming – the days of performance fees hiding in the shadows are almost over.
John Berry, Director
Pathfinder Asset Management Limited
Note to fund managers: If this commentary does not recognise any of your funds (where others are named) please let me know – I’m happy to update the article.
Disclosure of interest: Pathfinder is a fund manager and does not charge performance fees on its funds. Interests associated with Mint Asset Management Limited (mentioned in this article) hold a 5% shareholding in Pathfinder.
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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