In recent years there has been a lot of attention on the costs of investing. Across the world, fees have been coming down due to a combination of competition from low-cost index funds, and pressure from governments and regulators.
Performance fees have come under particular scrutiny. Questions have been raised about both their fairness and their complexity. The performance fees charged by the Allan Gray-Orbis Global Optimal Fund of Funds despite the portfolio’s sustained weak returns once again put this issue in the spotlight this week.
In South Africa, National Treasury has specifically excluded funds that charge performance fees from being used in tax-free savings accounts because they do not fit with the idea that these accounts should be simple, and low cost.
Yet advocates of performance fee structures continue to believe that they serve the interests of investors. If the asset manager is rewarded for delivering strong performance, they contend, then it’s ultimately the client who benefits.
The Allan Gray story
Allan Gray, for instance, is absolutely sincere in its belief that performance fees are an integral part of why it has been so successful. The firm entered the market at a time when the unit trust industry was dominated by the large insurers, who gave the impression that they were more concerned about selling products than ensuring that their clients benefited from using them.
By putting performance first, Allan Gray disrupted the market to the extent that it grew into the largest asset manager in the country, and has been able to maintain that dominant position for decades. Its use of performance fees, it believes, ensures that this focus is never lost.
However, the asset management industry of today is very different to the one Allan Gray entered in the 1970s. The level of competition is far higher, and delivering performance has become the first criterion by which any firm is judged.
The things that Allan Gray believes performance fees encourage – client-centricity and delivering value – have become what any asset manager has to foreground if they want to be successful and sustainable. Improved transparency in the industry and the rise of index funds have ensured that investors are far more aware of what their options are, and what they should be willing to pay for them.
Can you be better by trying harder?
There is also a growing body of evidence that the skill any asset manager possesses is only a tiny part of determining the return they are able to deliver. In addition, the ability of asset managers to deploy that skill is increasingly diminishing as markets become more and more efficient, and competition between them escalates.
In other words, there is no reason to believe that any asset manager will deliver better returns just because they are incentivised to try harder. There is no independent empirical evidence that suggests otherwise.
This is why performance fees are starting to appear a little dated. They may have been an appropriate solution to an industry problem that existed 50 years ago, but that problem no longer exists.
On the contrary, it is now becoming well understood that fees themselves are creating the greatest opportunity for industry disruption. Research by Morningstar and other academic sources has shown empirically that the best determinant of any fund’s future returns is the fee that it charges: funds that charge less will deliver higher returns.
This is not particularly revolutionary. It’s simply common sense, since every rand an asset manager receives as a fee is a rand taken from the investor’s return.
The irony, therefore, is that firms that charge asymmetrical performance fees and claim this is good for their clients would be delivering higher returns to those same clients if the performance fee didn’t exist.
And that is ultimately where the debate around what is truly in the interests of the end investor has to take place.
Can the interests of an asset manager truly be aligned with those of its clients through performance fees when this unequivocal conflict exists? More and more people in the industry don’t think so.
A number of asset managers in South Africa, including some of the largest firms like Old Mutual and Coronation, have done away with performance fees on many products. A number of boutiques are doing the same. Just this week RECM announced that it will be removing all performance fees from the RECM Global Flexible Fund, the RECM Equity Fund and the RECM Balanced Fund from April 1. The RECM Global Fund will follow suit as soon as it has managed the requirements in Guernsey, where the fund is domiciled.
This is a shift that appreciates that the reality is changing, and that it has to change.
Firms that don’t appreciate this run the risk of being caught in a way of thinking that is no longer relevant, and no longer resonates with investors. No matter how well it might have served them in the past, they have to seriously consider whether it will continue to serve them as well in the future.